REVIEW OF THE COMMODITY FUTURES TRADING COMMISSION'S
DISCRETION TO EXEMPT CERTAIN TRANSACTIONS FROM
ANTIFRAUD PROVISIONS OF THE COMMODITY EXCHANGE
ACT
Y 4. AG 8/1:103-13
Revieu of the Connodity Futures Tri...
xxx^nRINGS
BEFORE THE
SUBCOMMITTEE ON ENVIRONMENT, CREDIT,
AND RURAL DEVELOPMENT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRD CONGRESS
FIRST SESSION
ON
H.R. 2374
TO AMEND THE COMMODITY EXCHANGE ACT TO ENSURE THE CONTIN-
UED APPLICATION OF THE ACT'S ANTIFRAUD AND
ANTIMANIPULATION PROTECTIONS
APRIL 28 AND JUNE 30, 1993
Serial No. 103-13
Printed for the use of the Committee on Agriculture
U.S. GOVERNMENT PRINTING OFFICE
72-584 WASHINGTON : 1993
For sale by the U.S. Govemment Printing Office
Superintendent of Documents. Congressional Sales Office, Washington. DC 20402
ISBN 0-16-041700-7
REVIEW OF THE COMMODIH FUTURES TRADING COMMISSION'S
DISCRETION TO EXEMPT CERTAIN TRANSACTIONS FROM
ANTIFRAUD PROVISIONS OF THE COMMODITY EXCHANGE
ACT
Y 4. AS 8/1:103-13
Revieu of the Connodity Futures Tra.
,riRINGS
BEFORE THE
SUBCOMMITTEE ON ENVIRONMENT, CREDIT,
AND RURAL DEVELOPMENT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRD CONGRESS
FIRST SESSION
ON
H.R. 2374
TO AMEND THE COMMODITY EXCHANGE ACT TO ENSURE THE CONTIN-
UED APPLICATION OF THE ACT'S ANTIFRAUD AND
ANTIMANIPULATION PROTECTIONS
APRIL 28 AND JUNE 30, 1993
Serial No. 103-13/^,^^,
139^
Printed for the use of the Committee on Agriculture
U.S. GOVERNMENT PRINTING OFFICE
72-584 WASHINGTON : 1993
For sale by the U.S. Government Printing OlTice
Superintendent of Documents, Congressional Sales Office. Washington. DC 20402
ISBN 0-16-041700-7
COMMITTEE ON AGRICULTURE
E (KIKA) DE
GEORGE E. BROWN, Jr., California,
Vice Chairman
CHARLIE ROSE, North Carolina
GLENN ENGLISH, Oklahoma
DAN GLICKMAN, Kansas
CHARLES W. STENHOLM, Texas
HAROLD L. VOLKMER, Missouri
TIMOTHY J. PENNY, Minnesota
TIM JOHNSON, South Dakota
BILL SARPALIUS, Texas
JILL L. LONG, Indiana
GARY A. CONDIT, California
COLLIN C. PETERSON, Minnesota
CALVIN M. DOOLEY, California
EVA M. CLAYTON, North Carolina
DAVID MINGE, Minnesota
EARL F. HILLIARD, Alabama
JAY INSLEE, Washington
THOMAS J. BARLOW III, Kentucky
EARL POMEROY, North Dakota
TIM HOLDEN, Pennsylvania
CYNTHIA A. McKINNEY, Georgia
SCOTTY BAESLER, Kentucky
KAREN L. THURMAN, Florida
SANFORD D. BISHOP, Jr., Georgia
BENNIE G. THOMPSON, Mississippi
SAM FARR, California
PAT WILLIAMS, Montana
BLANCHE M. LAMBERT, Arkansas
LA GARZA, Texas, Chairman
PAT ROBERTS, Kansas,
Ranking Minority Member
BILL EMERSON, Missouri
STEVE GUNDERSON, Wisconsin
TOM LEWIS, Florida
ROBERT F. (BOB) SMITH, Oregon
LARRY COMBEST, Texas
WAYNE ALLARD, Colorado
BILL BARRETT, Nebraska
JIM NUSSLE, Iowa
JOHN A. BOEHNER, Ohio
THOMAS W. EWING, Ilhnois
JOHN T. DOOLITTLE, California
JACK KINGSTON, Georgia
BOB GOODLATTE, Virginia
JAY DICKEY, Arkansas
RICHARD W. POMBO, California
CHARLES T. CANADY, Florida
NICK SMITH, Michigan
TERRY EVERETT, Alabama
Professional Staff
DiANNE Powell, Staff Director
Vernie Hubert, Chief Counsel and Legislative Director
Gary R. Mitchell, Minority Staff Director
James A. Davis, Press Secretary
Subcommittee on Environment, Credit, and Rural Development
GLENN ENGLISH,
TIM JOHNSON, South Dakota.
Vice Chairman
JILL L. LONG, Indiana
EVA M. CLAYTON, North Carolina
DAVID MINGE, Minnesota
THOMAS J. BARLOW III, Kentucky
EARL POMEROY, North Dakota
TIM HOLDEN, Pennsylvania
CYNTHIA A. McKINNEY, Georgia
KAREN L. THURMAN, Florida
TIMOTHY J. PENNY, Minnesota
BILL SARPALIUS, Texas
COLLIN C. PETERSON, Minnesota
EARL F. HILLIARD, Alabama
JAY INSLEE, Washington
SCOTTY BAESLER, Kentucky
BENNIE G. THOMPSON, Mississippi
SAM FARR, CaUfomia
Oklahoma, Chairman
LARRY COMBEST, Texas
STEVE GUNDERSON, Wisconsin
WAYNE ALLARD, Colorado
BILL BARRETT, Nebraska
JIM NUSSLE, Iowa
THOMAS W. EWING, Illinois
JAY DICKEY, Arkansas
RICHARD W. POMBO, CaUfomia
NICK SMITH, Michigan
(ID
CONTENTS
April 28, 1993
Page
Combest, Hon. Larry, a Representative in Congress from the State of Texas,
opening statement 9
English, Hon. Glenn, a Representative in Congress from the State of Okla-
homa, opening statement 1
Prepared statement 4
Witnesses
Albrecht, William P., Acting Chairman, Commodity Futures Trading Commis-
sion 9
Prepared statement 46
Bair, Sheila C, Commissioner, Commodity Futures Trading Commission 11
Prepared statement 67
Dial, Joseph B., Commissioner, Commodity Futures Trading Commission 15
Prepared statement 80
Submitted Material
Corcoran, Andrea M., Division of Trading and Markets, Commodity Futures
Trading Commission, memorandum of April 9, 1993 85
Implementation of the Futures Trading Practices Act of 1992 87
June 30, 1993
H.R. 2374, a bill to amend the Commodity Exchange Act to ensure the
continued application of the act's antifraud and antimanipulation protec-
tions 94
Report from Commodity Futures Trading Commission 96
Combest, Hon. Larry, a Representative in Congress from the State of Texas,
prepared statement 92
English, Hon. Glenn, a Representative in Congress from the State of Okla-
homa, opening statement 89
Farr, Hon. Sam, a Representative in Congress from the State of California,
prepared statement 91
Witnesses
Arbor, Patrick H., chairman, Chicago Board of Trade 110
Prepared statement 134
Klein, R. Wayne, chief, securities bureau. State of Idaho, on behalf of the
North American Securities Administrators Association, Inc 113
Prepared statement 143
Raisler, Kenneth M., attorney, on behalf of the Energy Group 121
Prepared statement 165
Submitted Material
Albrecht, William P., acting chairman, Commodity Futures Trading Commis-
sion, statement 97
Bair, Sheila C, Commissioner, Commodity Futures Trading Commission,
statement 102
Bauman, Joseph, chairman. International Swaps and Derivatives Association,
letter of June 30, 1993 177
Dial, Joseph B., Commissioner, Commodity Futures Trading Commission,
statement 106
Redel, Donna, chairman. Commodity Exchange, Inc., letter of June 28, 1993 .. 180
(III)
REVIEW OF THE COMMODITY FUTURES
TRADING COMMISSION'S DISCRETION TO
EXEMPT CERTAIN TRANSACTIONS FROM
ANTIFRAUD PROVISIONS OF THE COMMOD-
ITY EXCHANGE ACT
WEDNESDAY, APRIL 28, 1993
House of Representatives,
Subcommittee on Environment, Credit,
AND Rural Development,
Committee on Agriculture,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:05 a.m., in room
1300, Longworth House Office Building, Hon. Glenn English (chair-
man of the subcommittee) presiding.
Present: Representatives Long, Barlow, Holden, Combest, Gun-
derson, Allard, Nussle, and Ewing.
Also present: Representative E (Kika) de la Garza, chairman of
the committee.
Staff present: Vemie Hubert, chief counsel and legislative direc-
tor; Fred J. Clark, deputy chief counsel; John E. Hogan, minority
counsel; Glenda L. Temple, clerk; Benjamin L Baker, James E.
McDonald, James A. Davis, John Riley, and David Ebersole.
OPENING STATEMENT OF HON. GLENN ENGLISH, A REP-
RESENTATIVE IN CONGRESS FROM THE STATE OF OKLA-
HOMA
Mr. English. The hearing will now come to order.
Last year with the reauthorization of the Commodity Futures
Trading Commission, the Congress wrestled with a very difficult
issue of what we do pertaining to the so-called "derivatives." Our
concern was that this was an issue in which we were not prepared
to make a decision, and as such, we had requested that studies be
done — studies that paralleled a study already underway by the
General Accounting Office.
We requested the Securities and Exchange Commission, as well
as the Federal Reserve and CFTC, to carry out studies pertaining
to these derivatives, and we also pointed out that we did not want
any action taken beyond maintaining the status quo. This was a
decision that the Congress was reserving for itself, as to what
should be done. The Congress has not yet reached that point, or
reached that decision.
In maintaining that status quo, the Congress did grant authority
to the CFTC to make sure that the courts did not act in preempt-
(1)
ing this decision, but it was made very clear that this was the deci-
sion to maintain the status quo only, not go beyond that point.
And at the time, I believe, I made the statement to the con-
ference that as far as I was concerned, should action go beyond
maintaining the status quo, that those who were involved would
have the opportunity to explain their decision to this subcommittee,
and it appears that that's where we are.
The so-called Brent Oil decision was the judgment that we recog-
nized needed to be addressed. We recognized that there was the
danger of the courts acting, and that it would also cause difficulty
as far as the oil markets are concerned. We had, in fact, instructed
the CFTC to take whatever actions necessary to maintain the sta-
tus quo at that time.
There was a request made in November, with regard to exemp-
tions. Those requests were considered by the CFTC, and from what
I understand — if I'm in error, we'll let the Commission correct me —
that the former chairman then provided to the Federal Register a
Eroposal for a rule that had not even been considered or looked at
y the other Commissioners, from what I understand.
It is disturbing then that earlier this month, we found newspaper
headlines which told us that the former chairman, shortly after the
publishing of that proposal in the Federal Register, joined one of
the very companies, who in November came before the Commis-
sion.
It is my understanding then that the action taken by the Com-
mission earlier this month was along those lines, and went beyond
simply maintaining the status quo.
For the first time, we have a regulatory body that exempts those
that they're regulating from fi*aud statutes, and while there is an
inclusion of antimanipulation, there's a question as to whether or
not it applies to the instruments that are being considered, since
under the law — particular provisions under the law for manipula-
tion apply to futures contracts.
We also find that this is a Commission that does not have a full
compliment of members, and this was a two to one decision. I did
note with interest that the only attorney on the Commission voted
against it. I also have taken note of the fact that we have a memo-
randum to the files dated April 8 of this year, from the Director
of the Division of Trading and Marketing, voicing concerns about
this particular provision, and particularly the antifi'aud provisions.
We also have another memo to the Director of the Economic Divi-
sion — fi*om the Director of the Division on Enforcement — who
voiced his concerns with regard to this action. It was noted by all
three of those who I mentioned — the Director of Trading and Mar-
keting, the Director of the Division on Economic Analysis, as well
as the Commissioner — that the purpose of the legislation last year
was to take us beyond an "all or nothing" position to not require
the Commission to view each decision on that basis, and that this
exceeded and went beyond what was intended, and I don't think
there's any question about that.
At no time during the discussion of the reauthorization of the
CFTC — certainly in the House, and I don't believe, in the other
body — did we ever have any Member who raised the question or
the wisdom of excluding any contract fi*om fi-aud statutes of the
Federal Government or the regulatory body involved, and as was
pointed out by the Director of the Division of Trading and Market-
ing, "To my knowledge, the Commission has never before exempted
transactions in products subject to its jurisdiction from the anti-
fraud provisions of the act, unless another regulatory regime clear-
ly applied to such transactions."
What is more disturbing is that this action by the Commission
may go beyond simply Federal law, and again, I quote the Director
in pointing out that, "In this case, the energy contracts exempted
from the CEA would also be exempt from State antibucketing laws,
and to the extent that they are not investment contracts or securi-
ties, or can be so designed, it would be exempt from security laws
as well."
I know that we will be provided with an explanation as to why
it was necessary to take this action, and I have to say that I, for
one, have been Einxiously looking forward to the explanation.
[The prepared statement of Mr. English follows:]
STATEMENT OF CONGRESSMAN GLENN ENGLISH, CHAIRMAN
SUBCOMMITTEE ON ENVIRONMENT, CREDIT AND RURAL DEVELOPMENT
OVERSIGHT HEARING ON AN ORDER OF THE
THE COMMODITY FUTURES TRADING COMMISSION
EXEMPTING CERTAIN ENERGY CONTRACT FROM
PROVISIONS OF THE COMMODITY EXCHANGE ACT
April 28, 1993
Today the Subcommittee is holding an oversight hearing to
review an order issued by the Commodity Futures Trading
Commission on April 13, 1993, that exempted certain energy
contracts from most of the provisions of the Commodity Exchange
Act, including the Act's anti-fraud provisions.
The Commission's order was issued under an amendment to the
Act enacted in, the Futures Trading Practices Act of 1992 that
added an new section 4(c). Section 4(c) authorizes the
Commission to "exempt any agreement, contract, or
transaction. . .either unconditionally or on stated terms or
conditions. .. from any of the requirements of ... subsection (a), or
from any other provision of the Act... if the Commission
determines that exemption would be consistent with the public
interest. "
The exemptive authority was granted to the Commission to
enable it to provide legal certainty to a number of existing
categories of instruments that have elements of futures contracts
but do not trade on the regulated futures exchanges . The legal
status of some of these contracts, including the 15-day Brent Oil
contract, was questionable in light of various court decisions.
Congress in granting the authority cautioned that the Commission
should use this exemptive authority sparingly until Congress has
had an opportunity to consider the results of various on-going
studies of the fast-growing market in derivative instruments.
However, the Conferees did recognize the need for the
Commission to act promptly in four areas — hybrids, swaps,
forwards, and deposits. The Commission previously granted
exemptions applicable to hybrids, swaps, and deposits.
As previously noted, the Commission, prior to granting an
exemption, is specifically required to find that the exemption is
consistent with the public interest. The Conference report on
the 1992 legislation make it clear that the public interest test
includes the national public interests as noted in the Act, the
prevention of fraud, and the financial integrity of the markets.
I believe that the report makes it quite clear that Congress
did not expect the Commission to exempt instruments and contracts
from the Act's anti-fraud provisions, unless there were extra-
ordinary reasons for doing so. Today's witnesses will be given
the opportunity to explain what the Commission believed those
extra-ordinary reasons may be in the case of the exempted energy
contracts — especially since the heads of the Commission's
Division of Enforcement and Division of Trading and Markets
advised against exempting such contracts from the Act's anti-
fraud provisions.
^vSTMo,
COMMODITY FUTURES TRADING COMMISSION
2033 K Sireel. NW . Washingion, DC 20581
(202) 254-7424
(202) 254 - 3534 Facsimile
DIVISION OF
ENFORCEMENT
MEMORANDDM
April 8, 1993
TO: Gerry Gay, Director,
Division of Economic Anal
FROM: Dennis Klejna, Director,,
Division of Enforcement
RE:
Exemption for Certain
tracts Involving Energy Products
This memorandum reiterates particular Division of
Enforcement observations concerning the draft Commission order
exempting certain energy contracts from most provisions of the
Act.^
The primary focus of our observations is on the absence of
retained anti- fraud jurisdiction under either Section 4b or
Section 4o. The new exempt ive authority granted by Congress
frees the Commission from having to make the all or nothing
jurisdictional decisions faced in the past. In this connection,
we are not aware of any Securities and Exchange Commission
exemption that excludes securities products from anti- fraud
jurisdiction. See , e.g. . Preliminary Note 1 to Regulation D, 17
C.F.R. § 230.501 et. seq . (1992) (registration exemption for
limited offerings); Preliminary Note 1 to Rule 144A, 17 C.F.R. §
230.144A (1992) (registration exemption for certain private
institutional resales) ; Preliminary Note 1 to Regulation S, 17
C.F.R. § 230.901 et. seq . (1992) (registration exemption for
offers and sales outside the U.S.).
The lack of fraud jurisdiction over exempt contracts may
become significant in two areas. First, the exemption will allow
for indirect public participation through otherwise qu§.lified
pools, trusts, or partnerships. The Commission's own experience
shows that it is difficult to predict the effect on retail
customers of Commission relief granted primarily to institutions.
In 1985, the Office of General Counsel issued Interpretative
Letter 85-2 to a regulated bank. The letter opined that
transactions entered into by the bank and retail metals dealers
■'■ The Division was consulted by the Division of Economic
Analysis on the text of the order and the acconpanying preamble,
and some, but not all. Division comments were incorporated in
that process.
were not futures, options, or leverage contracts. While the
opinion appears legally correct, the result was the birth and
proliferation of fraudulent sales operations that caused millions
of dollars in retail customer losses and led to Congressional
hearings.^ Moreover, there is a nearly limitless variety of
partnerships, trusts, or other business entities that could be
formed to engage in exempt energy contracts, and it would not be
difficult to structure such an entity to avoid securities laws.-^
We have not fully examined the myriad legal issues associated
with applying federal securities laws or state blue sky laws to
investment vehicles that could trade in exempt contracts, and
Section 12(e) of the Act may prevent the application of state
securities laws. It is also unclear how the Model State
Commodity Code would be applied to vehicles for indirect public
participation in the energy contract market.
In addition, the exemption would permit small businesses to
qualify for participation in the energy contract market, which
may raise policy issues about where the Commission wants to draw
the line between large entities presumably capable of protecting
themselves and smaller, albeit still "commercial," entities who
may lack the acumen to judge complex derivative instruments.''
The Commission already has seen one example of precious metals
contracts marketed to small businesses in a scheme that
ultimately resulted in retail customer losses and allegations of
fraud. See Krommenhoek v. A-Mark Precious Metals. Inc. . No. 90-
35604 (9th Cir. Sept. 27, 1991).
As I have noted in past discussions, there may be legal
obstacles to applying Section 4b to the contracts described in
the draft exemption. By its terms. Section 4b applies only to
futures contracts, and energy contracts would be subject to
Section 4b only if it could be proved that they were futures
contracts. Therefore, a court may not find those energy
contracts that fall within the scope of the Brent Interp. to be
futures contracts in light of the Brent Interp. 's unqualified
nature. However, the draft exemption goes beyond the Brent
Interp. -- indeed, the applicants have stated that it is their
intention to expand on the Brent Interp. -- and it could be less
difficult to apply Section 4b to those transactions that fall
^ See "The Scourge of Telemarketing Fraud: What Can be Done
Against It?" H.R. Rep. 102-421 (I02d Cong. 1st Sess. 1991) .
^ The SEC's problems in combatting "gold in the ground"
schemes shows that commodity investments can be packaged to avoid
SEC jurisdiction. See SEC v. Belmont Reid & Co. . 794 F.2d 1388
(9th Cir. (1986) .
^ In this regard, the Commission's "trade option
exemption," which does apply to small businesses, does not exempt
the subject transactions from fraud jurisdiction. See 17 C.F.R.
§ 32.4 (1992) .
8
outside of the Brent Interp. but remain within the scope of the
draft exemption.
Also, I understand that some have suggested that the "for or
on behalf of" phrase in Section 4b could be construed to create a
litigation obstacle to applying Section 4b to the type of
principal to principal transaction primarily contemplated in the
exemption. However, in many Commission enforcement actions,
courts have readily applied Section 4b in off-exchange cases
where boiler-rooms have sold their illegal contracts directly to
customers. In any event, the draft exemption now specifically
permits brokers or agents to facilitate energy contracts, the
very type of brokerage activity that Section 4b appears intended
to encompass.
Aside from the policy issues raised by not retaining anti-
fraud jurisdiction over the contracts, a decision not to retain
section 4o jurisdiction explicitly in the exemptive order could
raise practical issues concerning the Commission's jurisdiction
over pooled investment vehicles that engage in both exempted
energy contracts and regulated futures or commodity options.^
Where such persons or entities engage in fraud, the Commission
may face the argument that it lacks jurisdiction to prosecute
because the fraud is attributable in part or in whole to the
CPO's or CTA's conduct in connection with an exempted energy
contract. Thus, the Commission may face higher litigation costs
in pursuing fraud, even where it appears that the fraud pervades
an entire pool offering (for example, where false track record
information distributed to all customers of a pool that engages
in a variety of energy contracts is false because it conceals
losses solely on exempted contracts, would 4o jurisdiction
exist?) .
^ A footnote in the preamble to the order addresses this
issue, but the effect of the footnote in the face of unambiguous
language in the order itself is questionable.
Mr. English. Mr. Combest.
OPENING STATEMENT OF HON. LARRY COMBEST, A
REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. Combest. Thank you, Mr. Chairman. Mr. Chairman, as you,
possibly more than anyone else know, the Congress spent an inor-
dinate amount of time debating and agonizing over the finer points
of issues concerning the grant of certain exemptive authority to the
Commodity Futures Trading Commission.
Frankly, I thought we'd put these issues aside, at least until var-
ious studies, reports, and papers had been published. We were
waiting for these experts on all sides to make their cases concern-
ing many unanswered questions.
These questions include what these many derivative products
are, who should or should not be regulating them, and what is the
risk to the world's financial and trading systems should the Con-
gress decide to maintain the status quo?
I, too, am concerned that we not allow the Commission to get too
far off the reservation on these matters that last year's conference
committee agreed are difficult policy issues. They also may have
unknown real world implications far beyond the politics of split
regulatory and congressional jurisdictions.
Since last year's reauthorization granted the Commission the au-
thority to make such exemptions, our subcommittee should show
our concern for market integrity, while being careful not to second
guess every decision made by the Commissioners within their au-
thority.
Having said that though, I will reserve my judgment about
whether or not the Commission made the correct decision in ex-
empting participants from the antifraud provisions of section 4b of
the Commodity Exchange Act.
I look forward to hearing the Commissioners' reasoning this
morning. Thank you, Mr. Chairman.
Mr. English. Mr. Gunderson.
Mr. Gunderson. No statement, Mr. Chairman.
Mr. English. Today we will have a panel of witnesses, the three
remaining members of the Commission — the three that partici-
pated in this decision. We will have the Honorable William
Albrecht, who is the Acting Chairman, the Honorable Sheila Bair,
who is a Commissioner, and the Honorable Joseph Dial, who is a
Commissioner.
Mr. Albrecht, we'll let you begin with your testimony if you
would, please.
STATEMENT OF WILLIAM P. ALBRECHT, ACTING CHAIRMAN,
COMMODITY FUTURES TRADING COMMISSION
Mr. Albrecht. Thank you. My written statement, which I sub-
mit for the record, discusses in some detail the statutory back-
ground, the nature of the energy exemption, and the rationale be-
hind it.
In my remarks today, I will concentrate on two questions: Should
the Commission have reserved the antifraud authority of section 4b
of the Commodity Exchange Act, and how does our action fit into
10
the broader mosaic of issues currently affecting United States and
world financial markets.
Let me start with a few facts. On October 28, 1992, the Futures
Trading Practices Act, or FTPA, gave the CFTC the authority to
exempt given types of agreements from almost all of the require-
ments of the Commodity Exchange Act, including section 4b.
Neither the FTPA nor the accompanying conference report in-
cludes any separate discussion of 4b. The conference report does,
however, specifically direct the Commission to consider the exemp-
tion under discussion today.
Consistent with that legislative direction, on January 19, 1993,
the Commission voted to publish for comment the proposed order
granting this exemption. The proposed order did not seek to retain
4b jurisdiction.
When this proposed order was published in the Federal Register
on January 27, we specifically asked for comment on whether we
should reserve the applicability of section 4b. Sixteen comment let-
ters were received. None of them explicitly supported reserving 4b,
and most argued against it.
On March 8, the Federal Register provided notice that the Com-
mission would meet on April 6 to vote on a final order.
On April 1, the Federal Register provided notice that this meet-
ing had been postponed until April 13.
On April 13, the Commission approved a filnal order that was
much the same as the original proposal, and, in all respects, iden-
tical concerning section 4b.
In approving this order, I'm quite confident that we followed not
only the letter of the law, but the spirit as well — the spirit of
change embodied in our new exemptive authority.
The world of financial services has changed dramatically since
the CFTC was established nearly 20 years ago. At that time, fu-
tures markets dealt primarily with agricultural products. The U.S.
futures industry clearly dominated the world marketplace. There
was no significant competition from over-the-counter products. It
was easy to tell the difference between a "future" and a "forward."
It was easy to tell the difference between a "future" and a "secu-
rity." The distinctions among products were clear and meaningful.
Today, none of these conditions hold true. Financial markets
have evolved at a breathtaking pace, and that evolution continues.
Last year, Mr. Chairman, under your leadership. Congress faced
up to the realities of today's global marketplace. It recognized that
a regulatory regime, based on the world of 20 years ago, was caus-
ing serious problems for derivative markets in the United States,
and that it was hurting our international competitiveness.
Congress addressed this situation by passing the FTPA, and giv-
ing the CFTC the exemptive authority it so badly needed. The ge-
nius of this authority is that it frees us fi-om the increasingly
meaningless debate over whether something is a future or not. In-
stead, we can concentrate on designing the appropriate regulatory
scheme for products that have futures-like characteristics.
We can consider how much regulation by the CFTC is needed
based upon the characteristics of the market, such as the customer
base, the market's purpose, the potential for fraud, and the avail-
ability of other governmental oversight.
11
For some products, such as the energy contracts under discussion
today, this may mean almost no oversight by the CFTC. For others,
such as swaps, we've decided to maintain more oversight. This au-
thority also means that we can fashion different regulatory
schemes for futures exchanges if that is appropriate.
As I stated in my recent remarks at the annual meeting of the
Futures Industry Association, I believe that changes in technology,
customers, and competition mean that we can lighten the regu-
latory burden on exchange traded products that are limited to ap-
propriate persons, and offered through an electronic trading facil-
ity. This would be an important step for achieving the fair competi-
tion between exchanges and nonexchanges that Congress envi-
sioned when it enacted the FTPA.
In the case of energy transactions, we have fashioned an exemp-
tion for a fundamentally commercial market, whose purpose is to
move energy products in the stream of commerce. This market has
been in operation for over a century, and has gotten along just fine
without CFTC oversight. Its participants are large commercial enti-
ties, well aware of their contractual rights and legal remedies.
I am concerned that maintaining section 4b authority over this
market would provide little, if any, benefit, and perhaps cause very
real harm. If section 4b remains an issue, some international com-
mercial participants will continue to refuse to do business with
U.S. energy firms, and some U.S. firms will set up off-shore
branches.
In short, retaining 4b authority will damage U.S. international
competitiveness.
Let me emphasize, however, that the Commission's action does
not signal any abandonment of the principles of section 4b. There
has been no lessening of the CFTC's commitment to detect, deter,
and punish fraudulent activities. We have simply made an in-
formed judgment to devote our resources to those markets where
they are most needed and most likely to be effective.
Last October, Congress gave the CFTC the power to change an
outdated regulatory system. In November, the voters chose a new
President, the President elected on the platform of change — a
President whose campaign theme song was "Don't Stop Thinking
About Tomorrow."
If America's financial services industry is to be an effective inter-
national competitor, if the CFTC is to be an effective regulator, we
must let go of the past. We must forget about outdated jurisdic-
tional battles and outdated regulatory schemes, and start thinking
about tomorrow.
I believe that in adopting this energy exemption, the Commission
has done exactly that.
[The prepared statement of Mr. Albrecht appears at the conclu-
sion of the hearing.]
Mr. English. Thank you.
Ms. Bair.
STATEMENT OF SHEILA C. BAIR, COMMISSIONER, COMMODITY
FUTURES TRADING COMMISSION
Ms. Bair. Thank you, Mr. Chairman, members of the subcommit-
tee. Thank you for the opportunity to appear before you today to
12
discuss the Commission's order of April 13 exempting certain en-
ergy contracts from the Commodity Exchange Act. I voted against
this order.
As you know, it fails to retain the general antifraud provisions
contained in sections 4b and 4o of the Commodity Exchange Act.
I believe that exempting such transactions from statutory provi-
sions so basic and central to our regulatory scheme is a serious
misapplication of our new exemptive authority, and does set a dan-
gerous precedent.
At the outset, let me emphasize that I do not challenge the Com-
mission's legal authority to have granted energy contracts this ex-
emption, as ill-advised as I feel that action was, nor do I oppose
in concept an appropriately tailored exemption for the Brent Oil
market.
As the members of this subcommittee are aware, in September
1990, the Commission issued a statutory interpretation determin-
ing Brent crude oil contracts were forward contracts excluded from
the act. The Commission's action was prompted by a Federal dis-
trict court holding in the Transnor case that Brent contracts were
futures contracts subject to the CEA.
As former Commissioner Fowler West pointed out in his dissent,
the statutory interpretation went far beyond generally accepted cri-
teria in defining Brent contracts as forwards. Regrettably, the
Commission had little choice but to take such an approach because
then, unlike now, it lacked the authority to exempt futures con-
tracts from the act.
Because the Brent statutory interpretation was such a departure
from the traditional view of forwards, it left open the possibility
that a court could disagree with it, and still find the Brent con-
tracts were futures. Thus, it failed to provide the legal certainty
which Brent market participants sought.
As result, I believe it would have been completely appropriate for
the Commission to use its new exemptive authority to grant an ex-
emption for the Brent Oil market, while retaining antifraud and
antimanipulation authority. Unfortunately, the exemptive order ap-
proved by the Commission went far beyond what was necessary,
and significantly expands the Commission's 1990 Brent Oil statu-
tory interpretation.
For instance, the statutory interpretation was crafted to address
contracts for delivery in the Brent Oil market where a single cargo
consists of 500,000 barrels with a current market value in excess
of $10 million. The exemptive order, on the other hand, encom-
passes any contract for crude oil, as well as condensates, natural
gas, natural gas liquids, or any of their derivatives, regardless of
the size of the transaction.
The exemptive order also significantly expands the tj^es of offset
arrangements that are covered. The statutory interpretation de-
scribed arrangements requiring parties to negotiate offset arrange-
ments subsequent to entering into a Brent contract. Thus, they re-
tain significant delivery risk.
The exemptive order, on the other hand, recognizes master
agreements where the presumption is that the parties will offset
their transactions. Parties using these agreements can net all
13
transactions in a particular month with no intention to take deHv-
ery of any amount of the underlying commodity.
In addition, the kinds of entities eligible under the exemptive
order are significantly broader than those described in the statu-
tory interpretation. The statutory interpretation described eligible
participants as producers, processors, refiners, and merchandisers
of petroleum products, and other entities that buy and sell petro-
leum in connection with a line of business.
Entities eligible to participate under the exemptive order, how-
ever, include, among others, banks and governmental entities, as
well as business entities with a net worth exceeding $1 million, or
total assets exceeding $5 million. It is unnecessary for a business
to meet even these relatively low financial requirements if it can
secure a guarantee or letter of credit from a number of enumerated
entities, including a bank, savings and loan, broker-dealer, FCM —
even a floor broker or floor trader.
A footnote to the exemptive order also makes clear that specula-
tive investment vehicles, such as commodity pools, can qualify.
Finally, the exemptive order dilutes the commerciality require-
ment of the statutory interpretation to such an extent as to make
it almost nonexistent. The statutory interpretation emphasized
that transactions in Brent contracts are entered into for commer-
cial purposes in normal commercial channels, and must be related
to the business of the party.
The exemptive order, on the other hand, simply requires that en-
ergy contracts be entered into bj'^ "commercial participants who, in
connection with their business activities, incur risk, in addition to
price risk, related to the underljdng physical commodities."
This sounds impressive, but a publicly offered commodity pool or
a floor broker with a partial interest in a single oil well could, in
good faith, claim that it has met the risk portion of this test.
Indeed, it can be argued that an entity becomes a commercial
participant for purposes of the exemption, simply by entering into
an exempt transaction. This is because the terms of an exempt en-
ergy contract expose the parties to the contract to the risk of own-
ing the commodity.
In my view, the April 13 order is sufficiently broad as to easily
extend to transactions traditionally viewed as illegal, off-exchange
futures contracts under criteria applied by the Commission and the
courts.
Given that fact, I believe it was important to the integrity of our
enforcement program for the Commission to retain antifraud au-
thority, and can see no valid policy reason for the Commission's re-
fusal to do so.
One of the primary arguments that has been advanced for grant-
ing an exemption to the antifraud provisions of the act is that the
participants in exempt energy transactions are sophisticated insti-
tutional users, or entities of high net worth, who do not need the
antifraud protections of the act.
At the outset, I would note that if we are to rationalize exemp-
tions from antifraud £ind other components of our regulatory
scheme on the basis of the sophistication of market users, we might
as well close our doors tomorrow because approximately 98 percent
14
of users of regulated exchange traded futures are also sophisticated
institutional users or entities of high net worth.
Additionally, we all know that large firms are defrauded. The
Commission has brought or assisted in a number of actions where
the victims have been so called, institutional or sophisticated inves-
tors.
Further, the Commission's exemptive order permits participation
in exempt energy transactions by comparatively low net worth indi-
viduals or small businesses through the $1 million net worth
threshold for corporations and proprietorships and the sweeping
guarantee provisions. The participation of such entities not only
undermines the sophisticated institution argument for an exemp-
tion from the antifraud provisions, it also increases the likelihood
of exempt energy boilerrooms that target small business.
In addition, the order contemplates indirect public participation
in exempt transactions through a footnote permitting collective in-
vestment vehicles such as commodity pools, but because the order
fails to expressly retain section 4o authority, it is unclear if the
Commission has the authority to sue a registered commodity pool
operator for fraudulent representations to prospective pool inves-
tors concerning exempt energy transactions.
Another argument against retaining the antifraud provisions of
the act is that it would place an onerous burden on the energy
markets.
In response, I would first note that if the antifraud provisions of
the act were retained, they would only apply to fraudulent trans-
actions, which could also be shown to be futures contracts, other-
wise subject to our jurisdiction under the act.
In addition, basic CEA antifraud protections apply no more of a
burden on these markets than do State antifraud laws. Indeed,
given conflicts in State law, providing Federal forums and remedies
in connection with these transactions is, if anything, less onerous
in forcing participants, many of which are not U.S. companies, to
resolve their disputes under State law.
It should also be noted that at least some of the energy contracts
exempted by the Commission are also already subject to regulation,
including antifraud requirements, in the United Kingdom without
any apparent chilling effect on market participation.
The Commission, I believe, has set a dangerous precedent by not
retaining antifraud protections in this energy exemption. To my
knowledge, it is unprecedented for the Commission to provide relief
from antifraud protections for transactions that are not subject to
the jurisdiction of another regulator.
The Commission retained antifraud authority for swap trans-
actions which, like energy contracts, are principal-to-principal ar-
rangements in which brokers are permitted to facilitate treins-
actions.
What's more, the financial thresholds for eligible swap partici-
pants under the Commission's swaps rule are significantly higher
than those required of eligible energy contract participants. Thus,
the energy order, if anything, would seem to present a stronger
case for retaining antifraud protections than the swaps rule.
Commission rules governing trade options, which are options of-
fered to commercials in connection with their business, are also
15
subject to an antifraud provision, and of course, retention of anti-
fraud jurisdiction is standard in exemptions granted by the SEC.
By deviating from all of these precedents, my fear is that the
Commission has raised the expectations of other potential appli-
cants for exemptive relief, that they as well will be able to escape
sections 4b and 4o.
The primary reason the CFTC sought general exemptive author-
ity in its reauthorization was to have the flexibility to craft appro-
priately tailored exemptive relief based on public policy consider-
ations, instead of continuing to deal vdth the "all or nothing" juris-
dictional decisions forced upon us in the past.
In my view, we should have used our new exemptive authority
to clean up the confusion regarding forward contracts created by
the Brent Oil statutory interpretation, and I have no doubt that we
could have designed an exemptive order sufficient to meet the
needs of the Brent Oil market without compromising core provi-
sions of the CEA.
Unfortunately, we have continued to follow the "all or nothing"
approach, instead of weighing individual aspects of our regulatory
structure and making a reasoned determination as to which re-
quirements should apply.
That concludes my statement. Thank you, Mr. Chairman.
[The prepared statement of Ms. Bair appears at the conclusion
of the hearing.]
Mr. English. Thank you very much.
Mr. Dial.
STATEMENT OF JOSEPH B. DIAL, COMMISSIONER,
COMMODITY FUTURES TRADING COMMISSION
Mr. Dial. Thank you, Mr. Chairman, members of the subcommit-
tee. As I stated in my concurring opinion to the exemptive order
relating to certain energy contracts issued by the Commission on
April 13, 1993, I believe that this exemption was unique, given its
factual and legal background.
In my comments on the 13th, I expressed the belief that Con-
gress intended to allow existing energy contract practices in these
markets to continue to perform a useful function in the inter-
national marketplace.
I noted my belief then, and I respectfully submit to you today
that the Commission was exercising its exemptive authority in a
manner consistent with congression^ intent.
From November 16, 1992, until April 13, 1993, I rehed on the
plain language of the Futures Trading Practices Act and the con-
ferees' report as my guide in reaching a decision on the energy pro-
posal.
There are seven factors explicitly stated in the statute and con-
ference report that I referred to from time to time, again and again:
First, the conference report to the Futures Trading Practices Act
of 1992, in a paragraph in the exemptive authority section entitled
"Forwards," specifically provided that "[Tjhe conferees encourage
the Commission to review the situation and these contracts to de-
termine whether exemptive or other action should be taken." We
did that.
16
Second, the conferees indicated that the exemptive authority
should be used to "create legal certainty for a number of existing
categories of instruments, which trade today, outside of the forum
of a designated contract market." We took that into consideration
as it was written.
Third, the conferees further stated that the Commission should
use the exemptive authority promptly in the "areas where signifi-
cant concerns of legal uncertainty have arisen," including among
others, forwards. We acted promptly.
Fourth, the conferees specifically did not express a view regard-
ing the applicability of the Commission's Brent interpretation.
Fifth, the conferees expressly stated that the exercise of this ex-
emptive authority would not "require any determination before-
hand that the agreement, instrument, or transaction for which an
exemption is sought is subject to the act."
Sixth, the FTPA provides that the Commission may exempt an
agreement, contract, or transaction from section 4(a) of the Act "or
from any other provision of this act, except section 2(a)(1)(b), if the
Commission determines that the exemption would be consistent
with the public interest." We acted in accordance with those in-
structions.
Seventh, the conferees stated that the public interest test should
"include the national public interest noted in the act, the preven-
tion of fraud, and the preservation of the financial integrity of mar-
kets, as well as the promotion of responsible economic or financial
innovation and fair competition." We also tried to find proper bal-
ance in compl3dng with these instructions.
Given each of these factors, it remains my determination that the
exemptive order, as approved by the Commission, was appropriate.
The conferees chose to allow our prior statutory interpretation con-
cerning forward transactions to stand.
Furthermore, the language of the conference report clearly states
that CFTC does not have to find a contract within our jurisdiction
in order to exempt it.
Accordingly, I voted to provide the requested relief to existing
forwards-like markets, which could arguably come imder the pe-
numbra of the Brent interpretation, believing we should treat these
more "as excluded forwards" than as "exempted futures." As such,
I made the decision that the application of section 4b to these con-
tracts was inapposite.
I base this decision, in part, on my understanding of the legisla-
tive intent regarding regulation of forwards contracts. The section
2(a)(1) exclusion for such contracts was grounded on the premise
that "the act's regulatory scheme for futures trading simply should
not apply to private, commercial merchandizing transactions which
created enforceable obligations to deliver, but in which delivery is
deferred for reasons of commercial convenience or necessity."
That interpretation described the Commission's determination as
to what commercial-to-commercial transactions involving commod-
ities it considers to be within the scope of the section 2(a)(1) exclu-
sion.
Included within that scope of exclusions are "transactions which
create specific delivery obligations, * * * [which] create substan-
tial economic risk of a commercial nature to the parties * * *."
17
I believe that the contracts, which were the subject of the April
13, 1993 exemptive order, were sufficiently within the penumbra of
the Brent interpretation, so as to warrant similar treatment. These
contracts are restricted to commercial entities and create delivery
obligations that entail market risk.
Even though the parties may enter subsequent contracts to dis-
charge the obligations, this does not nullify the market risk attend-
ant to these transactions.
Similarly, even though the parties may satisfy the capacity re-
quirement of the exemption by executing bona fide contracts for
services such as production, refining, or storage, this still requires
the ability to bear market risk involved with the transactions.
Accordingly, I believe that the exemptive authority sufficiently
delimited the relief to existing markets, which come within the
general categories specified in the conference report paragraph
noted above, entitled "Forwards."
This, I believe, indicates that the fraud protection available to
current participants in the forwards market is sufficient for con-
tracts included in the exemptive order, and renders the application
of section 4b inappropriate,
I took this into account in reviewing the various components of
the public interest test, and I came to the decision to support the
energy exemption order as it was approved, after carefully review-
ing the nature of the relief requested, the existing markets, the
above-mentioned directives of the conference report, and the stat-
ute.
Thank you, sir,
[The prepared statement of Mr. Dial appears at the conclusion of
the hearing.]
Mr. English. Thank you, Mr. Dial.
The very purpose for the existence for the Commodity Futures
Trading Commission or any other Government regulatory agency is
to protect the public interest.
Mr. Albrecht, can you explain to me how opening the door to
fraud protects the public interest?
Mr. Albrecht. I think that we should first be clear on a couple
of facts: That essentially, what we have done is to maintain the
status quo in exercising our exemptive authority. We've attempted
to write a rule which leaves a market free from CFTC's jurisdic-
tion, which is currently free fi-om that jurisdiction.
The question is, should the specific antifi*aud prohibitions of the
Commodity Exchange Act, as enforced by the CFTC, apply to this
market?
There are lots of markets in which there is no oversight by the
CFTC, nor by any other governmental regulatory agency. There is,
however, a Department of Justice, which enforces Federal anti-
fi*aud statutes, there are State laws which enforce State antifraud
statutes, and there are civil remedies available for fraud.
The question is not, are we condoning fraud? The question is not,
are we repealing antifraud statutes? We're simply saying, here is
a market in which there are laws against fraud. The CFTC has
never overseen this market.
18
We do not think that it would be in the pubHc interest to extend
our antifraud jurisdiction to that market for the reasons that I've
outlined — I'd be happv to go through again.
Mr. English. Mr. Albrecht, that was not the question. The ques-
tion I asked you goes to the very core of the existence of the CFTC.
It was not your decision to make, nor were you a party to the
creation of the CFTC or the need for it, and certainly, it is not up
to you to make the decisions with regard to whether it needs to
exist.
It does exist because it has been determined by the people who
have the responsibility to make the laws of this country, there's a
need for it, not that some other governmental body can do it, and
we don't need it.
The bottom line question, again, is, given the requirements
under the law to meet the interest of the public — a public interest
test — how can you justify opening the door to fraud in these mar-
kets?
Mr. Albrecht. I simply have to take serious exception to the
way the question is stated. I do not believe that we have opened
the door to serious fraud. That simply is not true.
Mr. English. Mr. Albrecht, I don't see how it can be looked at
in any other way. Whenever you take it upon yourselves to exempt
a market from the fraud requirements of the agency, that opens
the door to fraud. There can be no other interpretation.
Now, we may argue as to whether or not there should or should
not be a CFTC, or whether there should or should not be any kind
of governmental agency overseeing particular markets, but the fact
of the matter is that unless you have — any time that you have been
charged with the responsibility of carrying out the laws and pro-
tecting the public interest, I see no way in which you can justify
lifting the requirements of the law exempting a market from the
fraud requirements of that agency. That is not in the public inter-
est.
Mr. Albrecht. Let me repeat one point that I made earlier
Mr. English. I'm not asking you to repeat the point, I'm asking
you to answer the question.
Mr. Albrecht. I m trying to answer your question, sir. I believe
. this is responsive to your question.
I do not believe that we have lifted fraud requirements from the
market. The market is subject to no more and no less fraud over-
sight on April 14 than it was on April 12, but let me address the —
perhaps, this will help answer the question.
Mr. English. Well, let's follow-up on that part right there. You're
sa5ring that it is subject to no more applications under the law on
April 14 than it was on April 12?
Mr. Albrecht. Yes, sir.
Mr. English. In what way?
Mr. Albrecht. On April 12, the CFTC did not have jurisdiction
over these energy contracts — they never exerted that. On April 13,
we voted to maintain that position.
Mr. English. Well, explain to me then, Mr. Albrecht, how in the
world a Government agency — how you, as a regulator, can exempt
someone over which you have no jurisdiction, if that is your posi-
tion.
19
Mr. Albrecht. I believe that is the heart and soul of this exemp-
tive authority. Some people have said the CFTC may have jurisdic-
tion over tins market — some people have said, "These may be
futures
Mr. English. Are you talking about people, or are you talking
about courts?
Mr. Albrecht. People — courts
Mr. English. Yes — they're all the same, in your opinion?
Mr. Albrecht. Well, judges are people, but — if the court-
Mr. English. Well, let's use — ^yes. The court has decided.
Mr. Albrecht. The court has said so, and
Mr. English. And you disagree?
Mr. Albrecht. A court said that
Mr. English. Do you disagree with that court?
Mr. Albrecht. Yes.
Mr. English. So you do not believe that the courts are correct.
Mr. Albrecht. I believe, in that particular case, that particular
court made an incorrect decision.
Mr. English. And you have chosen to overrule the court, is that
correct?
Mr. Albrecht. It's not in my power to overrule the court.
Mr. English. It is also not in your power to exempt from the
statutes, an entity over which you have no regulatory authority. Is
that not correct?
Mr. Albrecht. As I understand
Mr. English. Will you answer my question, please?
Mr. Albrecht. I'm trying to answer your question.
Mr. English. Well, either yes or no. Do you have the authority
to exempt from the statutes, an entity over which you have no reg-
ulatory authority?
Mr. Albrecht. Congress granted us the authority to exempt
markets without making the determination as to whether they
were subject to our authority, so the answer is yes.
Mr. English. So you have the authority to exempt — are you an
attorney, Mr. Albrecht?
Mr. Albrecht. I am not an attorney. I work with a lot of attor-
neys. I've received a lot of advice on this question from attorneys.
Mr. English. Ms. Bair, you are an attorney?
Ms. Bair. Yes, sir.
Mr. English. Mr. Dial, you're not an attorney?
Mr. Dial. No, sir. I am not.
Mr. English. Ms. Bair, under the law — I'm not an attorney ei-
ther. Maybe you could help us with a little legal work here then.
Under the law, is it possible for someone to exempt from the
statutes, if they have no authority over that entity?
Ms. Bair. No, sir. I don't believe it is, and to the extent we are
exempting things that are futures contracts, and therefore, are oth-
erwise subject to the Commodity Exchange.
Mr. English. So if these are not ftitures contracts, there's no au-
thority.
Ms. Bair. That's right. We cannot exempt something that's not
within our jurisdiction in the first place.
Mr. English. OK.
Ms. Bair. In my view.
20
Mr. English. Mr. Albrecht, that brings us back to the point. We
have the attorney here — your counsel on the Commission — who ad-
vises you that you can't exempt something that is not, in fact, cov-
ered under your jurisdiction.
Mr. Albrecht, Commissioner Bair is not my counsel. I have
counsel who advise me otherwise.
Mr. English. Oh, you get your own lawyer's advice. You get your
own counsel then, is that right?
Mr. Albrecht. As I think you well know, each Commissioner has
legal staff assigned to him. We have a number of attorneys within
the Commission. I rely upon them for advice.
I believe that they have told me that the conference report and
Commissioner Bair's statement are inconsistent.
Mr. English. You also had recommendations or views being ex-
pressed by both the Director of Enforcement and the Director of the
Division of Trading and Markets, is that right — on this issue?
Mr. Albrecht. Yes. But those were documents which were not
sent to the Commission. We forwarded them to you because we
wanted to send as much material as we could on this.
Mr. English. You're telling me then that these people did not
advise you of their views?
Mr. Albrecht. They did advise us of their views.
Mr. English. So you were aware of these views.
Mr. Albrecht. I was aware of these views.
Mr. English. And both had advised you of problems that they
saw with taking this action, is that correct?
Mr. Albrecht. I think it would be useful to
Mr. English. Well, just answer the question, Mr. Albrecht. Is
that right or not? Yes or no?
Mr. Albrecht. Yes.
Mr. English. So you had both the Director of Enforcement of the
Division of Enforcement and the Director on the Division of Trad-
ing and Marketing, who advised you that they saw problems with
regard to this matter, and even under the provisions of the law —
the basic responsibility that you have to protect the public inter-
est — you saw fit to move ahead, even over the reservations and
concerns being expressed by the only attorney sitting on the Com-
mission itself?
Mr. Albrecht. Well, that's an incorrect statement. They are
not
Mr. English. Tell me who in the Commission was recommending
that — ^who, with regard to the staff in the Commission, was
Mr. Albrecht. "Hie General Counsel, which is an office fiill of at-
torneys. The General Counsel herself is also an attorney.
Mr, English, I thought the General Counsel's place was to ad-
vise you what was legal and what's not. Is it also the General
Counsel's position to advise you what's good policy and what's
not — what's in the public interest and what's not?
Mr. Albrecht. The purpose of every division Director is to give
the full Commission their views on issues before us.
Mr. English. Whether they have any expertise or not.
Mr. Albrecht. Does who have any expertise?
Mr. English. Whether the division has any expertise or
Mr. Albrecht. They all have expertise, and
21
Mr. English. They all have expertise in every field that is within
the Commission, is that correct?
Mr. Albrecht. On most issues
Mr. English. Does your legal counsel have that kind of expertise
to what, in fact, is a problem from an enforcement standpoint, or
what, in fact, is good policy?
Mr. Albrecht. I believe so. I believe that — if I may be permitted,
sir — I believe that each division Director has expertise over a wide
range of issues.
Now each division Director is most particularly concerned about
a particular aspect of Commission policy — but they are staff.
They are, by and large, career bureaucrats. They don't have to
make the policy decisions.
They make the recommendations, and we make the policy deci-
sions. They make the recommendations from their perspective.
As it turns out, of the four major division Directors, two sup-
ported what we did, two would have preferred that we keep section
4b in.
I should also note that those
Mr. English. Well, who are the two? You've mentioned your
legal counsel — is that your personal legal counsel? Is that a head
of a department or — what?
Mr. Albrecht. The General Counsel, who is a head of a division,
and
Mr. English. Is that your personal counsel?
Mr. Albrecht. No, sir.
Mr. English. How many lawyers do you have over there?
Mr. Albrecht. On the Commission staff?
Mr. English. Advising you personally.
Mr. Albrecht. I have two lawyers on my own staff
Mr. English. And then you have a division of lawyers?
Mr. Albrecht. We have a lot of lawyers. We probably have
about 125 lawyers at the Commission.
Mr. English. Well, that may be part of the problem right there.
Mr. Albrecht. I've been known to say that. [Laughter.]
Mr. English. Well, you may have been right. [Laughter.]
Who's this other division head that was supporting — who didn't
feel we needed any fraud statutes?
Mr. Albrecht. That's our Chief Economist.
Mr. English. So you have the economist and your head lawyer,
who have said that they thought this was a great idea — "We don't
need any fraud statutes."
You have the head of the Division of Enforcement, and the head
of Trading and Markets, who say they think it's a bad idea.
Mr. Albrecht. That's right.
Mr. English. And you've decided the lawyers know more about
trading and marketing, and know more about enforcement than
those folks that are running those jobs, is that right?
Mr. Albrecht. I had the policy decision to make based upon all
of the factors in front of me, including the advice of everybody that
I talked to on the staff — which is a lot of people — including indirect
discussions with my two colleagues here. The Commissioners are
not really able to talk directly to each other because any two of us
together is a quorum.
22
I am confident that these ideas were fully discussed, and vetted.
If I pride myself on Einything as the Acting Chairman of this Com-
mission, I pride myself in the fact that I have brought more open-
ness to the process in the Commission than was there previously.
I have included my two fellow Commissioners at the very early
stages of every decision, I have encouraged the staff to make inde-
pendent decisions, and I encouraged the staff, in fact, to write
those memorandums if they disagreed with me because I wanted
them to get these ideas out in public and have them debated.
I think that leads to much better decisionmaking, but one of the
consequences of that is that you do have public disagreement about
issues. I think that's healthy.
I take full responsibility for being part of that process.
Mr. English. I think that's fine, but what you're going to have
to take full responsibility for are the consequences of the acts, and
this is going to be one that you're going to have to take the full
consequences for.
Mr. Dial, you're in favor of opening up the door for fraud, I see.
Can you tell me — explain to me how this is in the public interest?
Mr. Dial. Mr. Chairman, I'm not in favor of opening the door for
fraud.
Mr. English. Well, that's what you've done.
Mr. Dl\l. Mr. Chairman, my background is somewhat similar to
yours, in that we both come from an environment of values where
straight talk and tough enforcement are very important. The last
thing that I would do, sir, is act to open the door to fraud.
Mr. English. Mr. Dial, let me stop you right there, because there
is no question, that's what you've done.
Whether you intended to or not, or whether you recognized and
understood what you're doing or not, that's exactly what you've
done, and as I said — and as your Director on Trading and Markets
pointed out in her memo to the file — the Commission has never be-
fore exempted any transactions, subject to its jurisdiction in these
areas, from these antifraud statutes.
Now, never before have you done that. I have never, quite frank-
ly, heard of any other Federal agency — quite frankly, I consider
this to be outrageous.
And talking about straight talk — I'm giving it to you. You want
it, you're getting it. That's what it's all about.
And you say you're all for enforcement. Well, that's fine, but we
have to have something to enforce first of all.
If we wipe the laws off the books, then you don't have to worry
about enforcement, do you? Maybe that makes it a lot easier, but
the fact of the matter is, your action opened up the door to fraud
in this area.
Now there may be reasons — and I've heard, "Well, these are big
boys. Let them take care of themselves."
I would suggest to you, before this thing is done, as a con-
sequence of your actions, there are going to be some little people
that are going to get hurt, too. They may be big in our part of the
country, but they're little in this world, and it seems like, that any
time when the big people get hurt, they have to fall someplace, and
they fall on an awful lot of little people. The little folks end up
bearing a good deal of this burden.
23
Now if you want to go out and take off on some economic the-
ory — if you want to be a purist in economics and say, "By golly, we
believe in the free markets. Let's open it up all the way," then I
assume that you would be for wiping the fraud statutes off the
books of the States as well, but as Ms. Bair pointed out, this stat-
ute has no more of a burden than do the State statutes.
This would have no more of an impact than what we find taking
place in the States today, and — I just, quite frankly, have found the
action to be outrageous.
Mr. Albrecht made the point that we had a comment period.
What did you say — you have a dozen people writing in or some-
thing like that?
We got into the swaps issue, and you were going to do the same
thing on this, and I believe you got a call from me on that, didn't
you?
Mr. Albrecht. I didn't, but I believe the Commission did, yes.
Mr. English. Yes, they certainly did. And I made my views
known. Did I get logged in as commenting — with regard to the mat-
ter of fraud?
I — didn't put it down?
Mr. Albrecht. I beheve that
Mr. English. Members of Congress don't get their views re-
corded?
Mr. Albrecht. I was not in the Chairman's office at that time,
and I don't know exactly how that happened. It may or may not
have entered the official file.
It's my understanding that it came in fairly late, fairly well past
the closing of the comment period, but in general, it's our policy
that if a letter comes in, the letter will go in the comment file.
The phone call would not go into the comment file, because it's
a phone call, it's not a letter. One wouldn't want to possibly mis-
represent what a person
Mr. English. So because of the fact that I called the Chairman
of the CFTC to express my — quite frankly, grave concerns — is the
way I put it at that time — that the Commission was getting ready
to act with regard to swaps, and you were going to exempt fraud
in that area. You all were looking at doing it on swaps, too.
Mr. Albrecht. It was certainly under discussion.
Mr. English. It certainly was. It was barreling down the track
about 90 miles an hour.
I expressed some grave concerns about that, and then you de-
cided, "Well, as long as it applies to futures, we'll go ahead and in-
clude it."
But swaps are not futures contracts in your view — are they, Mr.
Albrecht?
Mr. Albrecht. I think that the
Mr. English. Is a swap a future?
Mr. Albrecht. I could say yes, I could say no. My main point
is it doesn't matter.
Mr. English. Well, either it is or it isn't.
Mr. Albrecht. It doesn't matter.
Mr. English. I would disagree with you, because you all agreed
to a ruling down there on this exemption with regard to swaps and
the swaps fraud provisions, and I believe the manipulation provi-
24
sions on swaps, and I believe the same thing is true with regard
to this particular contract. It applies only as it does under the fu-
tures provisions of the law.
Is that right, Ms. Bair?
Ms. Bair. Well, that's right. Congress did not require us to make
a determination in advance that contracts that met the specific re-
quirements of the exemption were or were not futures, but clearly,
again, in my view, you cannot exempt something that's not within
your jurisdiction, which is a futures contract.
Both the swaps rule and this rule, I believe, are sufficiently
broad to include things we've traditionally viewed as futures con-
tracts.
Mr. English. But if you're viewing it the way Mr. Albrecht's
counsel is — well, that's fine. We can go ahead and put that on the
books because we don't view that as being a futures contract any-
way; therefore, we have no regulatory authority anyway — right?
Ms. Bair. If that's the analysis, we didn't need exemptive author-
ity because, again, it would be
Mr. English. But am I correct in the way that — the trail that
that follows?
Ms. Bair. Yes. I agree.
Mr. English. So if you're Mr. Albrecht, well, you don't recognize
any of it — "It doesn't matter whether it's on the books or not be-
cause I choose not to view that to be a futures contract."
Is there any such thing, Mr. Albrecht, as a futures contract if it's
not traded on an exchange? Does it have to be traded on an ex-
change to be a futures contract, or not?
Mr. Albrecht. I think that is a question that we no longer have
to answer. The question is, if something has futures-like
characteristics
Mr. English. I'm asking your personal point of view, Mr.
Albrecht. You're the Chairman. You've been sitting down there on
the Commission.
You're the ones that make the judgment call. I'm trying to figure
out whether we have anjrthing covered by fi*aud statutes. Maybe
you don't view the stuff on the exchanges being futures anymore,
for all I know.
Mr. Albrecht. I believe they are futures.
Mr. English. So everything on an exchange is a futures contract,
is that right?
Mr. Albrecht. If it's traded on a futures exchange, I believe it's
a futures contract.
Mr. English. Is there anything that's not traded on a futures ex-
change that is a futures contract?
Mr. Albrecht. There can be illegal off-exchange futures con-
tracts.
Mr. English. Do you know of any?
Mr. Albrecht. Not at the moment. We would have shut them
down if we had.
Mr. English. So therefore, if you haven't shut them down and
they're not traded on the futures exchange by your very definition,
they are not a futures contract.
Mr. Albrecht. Mr. Chairman, I do not think it is useful to spend
a lot of time worrying about whether some of these instruments
25
with futures-like characteristics are futures contracts. We have
wasted an awful lot of time over the past 20 years doing that.
Mr. English. Mr. Albrecht, let me just point out to you, it is up
to this subcommittee and this committee and this Congress to
make that decision, not you, and that's exactly what the problem
is here today, Mr. Albrecht, because I think you have taken it on
yourself to make these decisions.
You have taken it out of the hands of Congress, and as Commis-
sioner Bair pointed out in her statement — and I assume, Commis-
sioner Bair, you made that point to the other Commissioners — that
in fact, you're going beyond what was the intent of the law, and
certainly the intent of the exemption.
Mr. Albrecht. It was not my intent to do that. I believed, and
I still believe that what I did was consistent with the law, consist-
ent with the conference report, and I thought it was consistent
with the intent of Congress.
Perhaps I'm mistaken, but I thought it was.
Mr. English. You have a lot of folks that told you it wasn't, so —
we'll take another round on this in just a little bit, but I'm sure
Mr. Combest has a few questions.
Mr. Combest. Thank you, Mr. Chairman,
The whole issue of dealing in futures is an area which is not
something that all of us have a personal awareness of. It is some-
what of a unique business, and given the fact that we're dealing
with this in terms of legal questions — I'm not an attorney either —
let me see if my understanding of the questions is correct. Please,
make any changes in my scenario of what has happened here —
any of you, that you would see — because I want to make sure that
I'm understanding this correctly.
The question of jurisdiction in enforcing fraud provisions that
were granted to the Commodity Futures Trading Commission had
to do with whether or not the type of transaction fell within your
jurisdiction. If the transaction did not fall under your jurisdiction,
laws you are given to prevent fraud would not be applicable. As I
believe, Mr. Dial mentioned in his testimony, there are statutes on
the books to deal with fraud, if, in fact, fraud is found. On this
question, your legal counsel, had differing opinions on the
interpretiation and the intent of the Re-authorization Act as grant-
ed by Congress last year. You all considered the counsels' advice,
you had a difference of opinion as to the type of transaction this
particular thing was, and based upon what each of you viewed and
looked at differently, you came to different conclusions.
Mr. Albrecht. If I could stop
Mr. Combest. Please do.
Mr. Albrecht. I think that's true as far as it goes. I think that
we all continue to struggle with this issue of how to interpret the
exemptive authority.
Some people still use the futures/forward dichotomy and try to
stick it into one of those. I, myself, view that as not terribly produc-
tive, and I've tried to view it in terms of, "Here's something we
might have jurisdiction over. What's the appropriate sort of regu-
latory policy to follow?" But, I think we all agree that we could
have come down differently on this, and the potential for different
outcomes is substantial.
26
I do think that most of the transactions at issue are forward con-
tracts. They're well beyond the reach of the Commodity Exchange
Act.
It's possible that some of the contracts that are at issue here,
under various readings of the Commodity Exchange Act, could be
considered subject to our authority.
The question then is, should we exert our authority over those
contracts?
I think there are two issues: One, what are these things? Then
the other is, once we've somehow sorted through what they are,
what we should do about them.
Mr. COMBEST. At that point. Commissioner Bair or Mr. Dial, do
you have a comment.
Ms. Bair. Yes. Again, I agree. I think this energy exemption is
sufficiently broad to include things that are traditionally viewed as
futures contracts. I also think it's sufficiently broad to be able to
be misused by those who might want to set up fraudulent activi-
ties — boilerrooms targeted to small businesses — along the lines of
what we've seen in the past.
Because we have not retained antifraud authority, we have re-
moved our capability to prosecute those types of cases, should they
occur. I think it's very easy to construct something that would fall
within the parameters of the exemptive authority, and we just sim-
ply would not now have the antifraud — residual antifraud author-
ity to do it — to go after these folks, so that's my concern.
My personal view as a policy matter — I think, whenever we're
using 4(c) to grant exemptions to things that would otherwise fall
within our jurisdiction, we should retain antifraud authority. I
think it's just very basic and central to the Commodity Exchange
Act.
The only exception I can see is, for instance, the hybrid area
where you have either an SEC regulatory scheme or banking regu-
latory scheme with very extensive financial regulatory provisions
against fraud that would apply to these instruments, so I think it
was justified there, but otherwise, I don't think we should ever do
it.
Mr. COMBEST. Mr. Dial.
Mr. Dial. Yes.
Mr. COMBEST. You had some comments about my premise?
Mr. Dial. Yes, sir. I agree with your premise, and once again, as
I stated in my comments, I went to the language of FTPA and to
the conferees report, the conferees did not "require any determina-
tion beforeh£ind that the agreement, instrument, or transaction for
which an exemption is sought is subject to the act."
Also, the conferees allowed the status quo to be maintained with
regard to the Brent interpretation.
Given those two factors, we — forwards are excluded from our ju-
risdiction.
In order for us to include the 4b antifraud provision in the en-
ergy exemptive order, we would have to have jurisdiction over
these transactions.
My interpretation, and that of the legal counsel whose advice I
sought, made it very clear that Congress recognized that we did not
have jurisdiction over forwards, and these energy contracts are for-
27
wards, and therefore, we did not have the legal authority to include
4b in this exemptive order.
Mr. COMBEST. I can understand how people can look at the same
information and obviously come to different conclusions. We do that
every day here. We have the same information provided to us, and
many of us come to many different conclusions.
Even though there was not — or would not be — the potential for
the Commission to bring fraud charges if this exemption was grant-
ed, there would still be other means by which an individual who
felt defrauded under this transaction could go through the legal
system and claim fraud.
Mr. Dial. Yes. Let me
Mr. COMBEST. Commissioner Bair started to respond — excuse me.
Ms. Bair. I would say — ^yes. The argument has been made that
State antifraud laws — regular old common law antifraud provisions
could apply to these transactions.
I think, though, you need to go back to the whole reason why the
CFTC was created, and the SEC, and our whole Federal system of
financial regulation, which was a recognition of the inadequacy of
State remedies for these very complex, frequently cross-border, fi-
nancial or fraudulent transactions.
I mean, if you carry that argument to its logical conclusion —
again, you don't need a CFTC — even if there weren't a CFTC, if
there were frauds being committed on exchanges, you could always
go back and use State common law fraud, so I don't really see that
that is an adequate basis for which — for us to give up our antifraud
authority.
Mr. COMBEST, Yes. And I'm not trying to argue that you should.
I would just
Ms. Bair. Yes. But, that is the-
Mr. CoMBEST. Again, for my own perspective
Ms. Bair, That is the argument.
Mr. COMBEST. But let me carry that a step further. Generally,
you would expect then — or it would be common practice that if
someone felt defrauded, they would bring legal action under the
fraud statutes given to the Commission or to another authority —
be it SEC, CFTC, or whomever — that would be governing the ex-
change under which it was dealt?
Ms. Bair. I think the question here is whether the CFTC can
bring the action, not whether a private party can. And 4b applies
to actions brought by the CFTC.
Mr. CoMBEST. Right.
Ms. Bair, And again, frequently you see — with these boilerroom
operations — many people being ripped-off, with various levels of
economic resources of sophistication to bring the action themselves.
Again, I think that's why you have a Federal agency taking the
lead with the expertise and with the resources to close these kind
of operations down.
Mr. COMBEST, Yes, sir? I didn't mean to cut you off. She just
started to respond.
Mr. Albrecht. All right. Thank you. First of all, we should rec-
ognize the fact of what 4b is and what 4b isn't; 4b is designed to
protect customers. It's designed to protect people who are being
28
sold something by a broker, being defrauded by a floor trader, or
something Hke that.
It is not designed to protect people in a principal-to-principal
market. Most of these transactions we're talking about are beyond
the reach of 4b, so to even say we're maintaining 4b — to say that
does much would be illusory.
There's a lot of illusion that goes on about regulation, so I think
it would be very foolish and dangerous, in fact, for us to say we're
regulating a market when we do not have the authority to do
that — when that regulation wouldn't do anything.
Now, I think we also must not lose sight of the fact that if people
breach the terms of this exemption, they are subject to the Com-
modity Exchange Act. The type of activity that we've typically
seen— boilerrooms — they're not covered by this exemption. That's
illegal activity under the terms of this exemption, and we would try
to stop it.
We have the authority to investigate all charges of boilerroom op-
eration, and we have the authority to see if people are abiding by
the term. .
It's only people that abide by the terms of this exemption, which
is for a principal-to-principal market — a commercial market— peo-
ple that meet the various standards with appropriate "personhood"
that are contained in this statute and our exemption, so I think we
have to understand that— one, it doesn't — 4b doesn't reach most of
the transactions we're talking about here — the types of boilerrooms
and illegal bucket shops, and so forth. Those are going to get
caught up by us anyway.
Ms. Bair. Could I please respond to that?
Mr. COMBEST. Yes.
Ms. Bair. First, on the principal-to-principal argument, this is
something I've heard before— that 4b won't apply to principal-to-
principal transactions. We have brought cases— boilerrooms are
typically set up as principal-to-principal transactions.
Mr. Klejna's memo, that the Chairman referenced earlier, ad-
dresses this point specifically, and says we have successfully pros-
ecuted these types of cases where the scams are set up that way,
and it has not become an issue before, and I don't think it should
be. I think you want to have fraud applying to principal-to-prin-
cipal transactions as much as you do to broker transactions.
Also, I cannot more vigorously disagree with the statement that
we can still go after boilerrooms. That's the whole point. This is an
exemption from our jurisdiction.
Even if our Enforcement Division could go in and prove that it's
a futures contract — and would otherwise be subject to the CEA —
if the promoter of whatever the fraudulent scam is has successfully
constructed the fraudulent activity in a way that fits the param-
eters of this very broad exemption, we do not have jurisdiction any-
more to go in and shut these things down.
Mr. COMBEST. So what you're saying is, that if a transaction was
crafted in such a way as to create an exemption
Ms. Bair. If any— that's right. Any transaction that falls within
the parameters of this exemption
Mr. COMBEST. Yes.
Ms. Bair. We do not have jurisdiction to prosecute.
29
Mr. COMBEST. Right.
Mr. Chairman, in the interest of other members, I'll wait for the
next round. I have some more questions.
Mr. English. Mr. Barlow.
Mr. Barlow. Thank you, Mr. Chairman. I want to associate my-
self with the gentleman who has very serious concerns about
boilerroom operations, and we need to stay on top of this situation
for the sake of investors across the country, but let me just take
a little bit different tact — and bear with me, I'm learning my way
here.
We're talking about contracts here that are hybrid, swaps, de-
rivatives — is derivative a generic name for this whole area in terms
of a brokerage or a trader putting together a number of different
types of vehicles — investment vehicles — and then selling them as
one unit — this whole derivative area — are we talking about this?
Ms. Bair. Well, derivatives is kind of a broad, generic term that
can include anything, including regulated futures and options. I
think what we're mainly focused on here are off-exchange deriva-
tive products that look like — if not, in fact, are — futures contracts,
as those that have traditionally been defined by the courts, but to
go under this specific order, we're talking about energy contracts.
Mr. Barlow. Well, now is it possible that you could have a trad-
er or a floor trader manying in derivative oil futures, as well as
wheat futures and com futures and so forth, as one vehicle?
Ms. Bair. Do you mean in boilerroom contracts — there would
be
Mr. Barlow. I'm moving beyond the boilerroom. I have a concern
with the whole way the derivatives process is developing in — not
just our Nation, but in the world, with billions and tens of billions
and trillions out there on the line, and I'm very sensitive to the fact
that the regulatory authorities are trying to reach out to make sure
there's not fraud, and just generally shoddy practices going on that
can lead to — down the line — a disaster, and I'm very concerned
fi-om the standpoint of our jurisdiction about the grains, and even
in the oil area.
We have in our area of the country, a river transport industry
that carries a lot of crude, and I would not like to see a situation —
an emergency situation blow up that involved the unraveling — be-
cause of fraud — of a number of contracts, and the oil is in the proc-
ess of being transported by a barge line, and all of a sudden this
barge line is in receivership because of fraud, so I would like to see
the broad reach of fraud be kept.
I think everybody feels that we have an industry here that's ex-
ploding in all directions — ^hopefully, most of which is constructive,
but if it's not policed properly, we can see fraud come up in agri-
culture to the extent that it's involved or wound into these deriva-
tive swaps in the futures area, and even the oil energy area can
be severely impacted.
Does anybody want to respond to that in general terms? It's more
a statement than a question, but — Mr. Albrecht?
Mr. Albrecht. I certainly agree that this is an industry or a
market or a set of markets that's expanding dramatically in a vari-
ety of derivative products — products whose value is based on the
value of some underl3dng products.
72-584 0-93-2
30
An interest rate future is a derivative because its value is de-
rived from the value of the interest rate. An oil future is a deriva-
tive because its value is derived from that, and they are increas-
ingly complex. It's a very difficult task to put together the appro-
priate regulatory scheme for any of those. How much should we
rely upon regulation, how much should we rely upon State law,
regular Federal law, and how much should we rely upon private in-
centives.
All of us at the Commission, whether we agree or not on a par-
ticular outcome, are very much concerned about that, and are doing
our level best to try to do what we can within the statute that
we've been given. It's something we have been instructed to report
to Congress on, and we will do so by the end of October of this
year, and I'm sure it's something Congress will revisit from time
to time, both in our area, and in many other areas.
Mr. Barlow. So even though we're focused here on a particular
law suit involving a Brent Oil contract, under these swaps and de-
rivatives, other futures could be wound into a package here, and
that might involve wheat futures or other things. It all depends
upon the imagination of the trader, right?
Ms. Bair. Could I just make one point of clarification?
Mr. Barlow. Yes.
Ms. Bair. This order — and this is a very important point, I
think— this order is not confined to the Brent Oil market. This
order is not confined to any particular identifiable energy market.
Mr. Barlow. Right.
Ms. Bair. This order extends to a broad range of energy trans-
actions based on oil, natural gas, their derivatives, and conden-
sates, so I think — to the extent your specific concern is with regard
to off-exchange oil markets, you may very well have a concern with
the Commission's failure to retain antifraud authority with regard
to this energy exemptive authority.
Mr. Barlow. Yes.
Ms. Bair. It does encompass all those markets, not just Brent
Oil.
Mr. Barlow. Right. So oil — and to the extent that people are get-
ting into derivatives that marry other futures contracts, a default
in an oil contract could have repercussions into wheat and com and
so forth, no?
Mr. Albrecht. This exemption is limited to energy. I think we
have to be very clear about that. There is no expansion of this par-
ticular exemption beyond the field of energy.
Now the Brent interpretation by contrast, while designed to deal
specifically with the problem rising out of the Transnor case, is
much broader than our exemption because it talks about delivery
of physical commodities in general, and it is not specifically limited
to oil, even though it was designed in response to a problem in the
oil market.
Mr. Barlow. Well, you might have a trader in oil who takes an
extreme position in the oil futures market, and he's now outside
the fraud provisions and he moves into unwise transactions — alleg-
edly fraud — but he may lay off his exposure in the wheat market
or the com market or the cotton market or a number of other mar-
kets. If he defaults, it's going to have impacts there, right?
31
Mr. Albrecht. You really need more details, I think, to-
Ms. Bair. This order does not apply to agricultural derivatives.
Mr. Barlow. No. That's true, but if he defaults
Ms. Bair. Indirectly, there could be an impact.
Mr. Barlow. If he defaults in the oil area because you've re-
leased him from surveillance, it will have impacts in these other
areas, right? As those futures have to be unwound quickly or
Ms. Bair. I can't say that it wouldn't. I think, also, farmers and
agricultural co-ops, to the extent — they are energy users and may
have inventories of fuel on the premises. They could very well qual-
ify as qualified participants for these exempt energy contracts, and
be some of the small businesses that might be the victims of fraud
in operations that would meet the requirements of this exemption,
yes.
Mr. Barlow. That's true.
Mr. Dial. Congressman Barlow, if I might make an observation.
At any point in time, that an instrument is a futures instrument
or the transaction is one that is traded on a multilateral exchange
facility, then it comes under our jurisdiction, so even though some-
one might design some derivative hybrid-type product that would
involve energy and the ag commodities, or even a financial instru-
ment once a ftitures transaction becomes a part of that, that aspect
of that derivative product comes under our jurisdiction, and it is
subject to 4b.
Mr. Barlow. Even if energ/s included?
Mr. Dial. If it is outside of this exemption that we're talking
about, and is futures, then it comes under our jurisdiction.
And as a point of clarification — in as much as I see the direction
that your question is headed in — let me call to your attention, re-
spectfully, that in this exemptive order it says, "And whereas this
order is limited to commercial participants who, in connection with
their business activities" — it lists several things — but No. 4 says,
"Commercial participants who, in connection with their business
activities, are not formed solely for the specific purpose of constitut-
ing an eligible entity pursuant to this order."
In other words, if someone forms a pool and they use that as a
fraudulent vehicle, it does not come under this exemptive order,
and we do have the opportunity to investigate that fraudulent,
volatile conduct.
Ms. Bair. I would have to register a disagreement with my col-
league on that point. That particular provision applies only to enti-
ties that were solely formed for the specific purpose of qualifying
as a participant for an exempt transaction, so I think commodity
pools, FCM's, floor traders, floor brokers — if they have minimal
participation in regulated futures markets, they haven't been
formed solely for the purpose of qualifying to be a qualified partici-
pant for an exempt transaction.
Similarly, a boilerroom could simply have a partial interest in an
oil well, and also fall outside the bounds of that requirement. I
think, because of those qualifiers, it's a very limited use.
Mr. Dial. But they also would have to meet all of the other re-
quirements to be a qualified participant.
Mr. Barlow. Yes.
32
Mr. Chairman, I'm just concerned that the farmers are being ex-
posed here, and I'd like to see the fraudulent provisions kept as
broad as possible.
Mr. English. Thank you very much, Mr. Barlow.
Mr. Allard.
Mr. Allard. Thank you, Mr. Chairman. I was on the conference
committee last year, and what I remember is that the committee
wrestled a lot with the definition of these derivatives or swaps or
hybrids or whatever, and there was some discussion about impact
on international markets and how you define them and enforce-
ability, and it seems to me like the results of a lot of that, as we
decided at that conference committee, were that we set up a mech-
anism to monitor and gather information on how provisions of the
bill worked in the form of a study, and determine if more regula-
tion oversight is necessary.
Are you aware of any fraud, now going on, with these particular
oil
Mr. Albrecht. No. I'm aware of one case in a court in New York
or Connecticut, in which a firm has been prosecuted for fi-audulent
arrangements with a bank. This was a firm that was in the market
that has been taken care of by Federal authorities.
Mr. Allard. But it's been enforced, and as far as you know, as
a result of your action here, you haven't — there hasn't been — and
I guess there haven't as many times, but there hasn't been any
Mr. Albrecht. There hasn't been any time
Mr. Allard. Anything that's come up yet?
Mr. Albrecht. It still has not gone into effect yet.
Mr. Allard. So again, we're sort of back where we were in the
conference committee, where some of the decisions that we maybe
made in the legislation — we haven't had enough time yet to see
how the enforcement is going to be applied and whether it's going
to have a real impact or not, and one of the things that we wrestled
with in the conference committee is that we can talk about boiler-
rooms, and all of us think in terms of a domestic company dealing
with American citizens.
Then we get into the international market, and then how does
that get applied with the international trade? I guess that's kind
of where I'm thinking — we have businesses that deal internation-
ally — at least, I can visualize that — for example, airline companies
and fuel purchasers and whatnot.
In your opinion, how would we enforce — if we were to go ahead
with what the chairman has suggested — how would we enforce that
on a — or how would that interact with a foreign customer?
Mr. Albrecht. It gets difficult. We have, over the past few years,
worked fairly close with authorities in other countries and we have
established memorandums of understanding and so forth with
them. We share information £ind we help one another in enforce-
ment efforts.
Once fraud goes international, it becomes a little bit more dif-
ficult to catch and work with, but we continue to try to do that in
all areas that are under our jurisdiction.
It's a resource-intensive effort. It takes a lot of time, it takes a
lot of money, but we continue to do that.
33
Mr. Allard. We could have a foreign customer that could file
suit in U.S. courts against a domestic company? Is that possible?
Mr. Dial. Sure.
Ms. Bair. We have that now.
Mr. Albrecht. Yes. That's the situation.
Mr. Allard. That's possible?
Mr. Dial. Yes.
Mr. Allard. Is it possible for a domestic company to file suit
against that foreign customer in U.S. courts? And if he's not a citi-
zen of the United States, how would our laws apply to him?
Ms. Bair. Well, if he's doing — I'm not an international law ex-
pert. I believe if he's doing business in the United States, though,
that you usually can
Mr. Allard. So what I'm wrestling with is how do we make
United States law apply to foreigners who aren't citizens.
Ms. Bair. Right. Could I back up just for a minute?
Mr. Allard. Yes.
Ms. Bair. A couple of points, I think, need to be made. Again,
this order is not confined to the Brent Oil market. This order is not
confined to international markets.
This order applies to any "energy transaction which meets the re-
quirements." That could be a completely domestic transaction.
Mr. Allard. Or it could be international.
Ms. Bair. Or it could be international.
There are also, plenty of examples of fraudulent activity in
boilerroom operations that come to our attention involving energy
products, so I think that point needs to be made, too.
Also, I would reemphasize, as I did in my statement — my written
testimony — the U.K. does — even in the international Brent Oil
market, the U.K., which is frequently pointed to as a "good regu-
lator," in terms of fostering international competitiveness of U.K.
businesses — they have antifi*aud requirements that apply to the
Brent Oil market.
Mr. Albrecht. Could I respond to that?
Mr. Allard. Yes.
Mr. Albrecht. Specifically, the question of the U.K. and its reg-
ulatory regime has come up, and I think it's worth talking about.
First of all, I think we all should understand that the U.K. sys-
tem and the U.S. system are very different. No one would probably
want to transplant their system here, and they wouldn't want to
take ours.
In general, their system is a much less regulatory system than
ours — a much lighter hand. To the extent there's a comparable
agency to us and the SEC, it's the SIB. It has much less power
than either the CFTC or the SEC. They rely much more heavily
upon self-regulation than we do.
Now what Commissioner Bair is referring is the oil market code
of conduct, which is put forth by the Securities and Investments
Board. The Securities and Investments Board issues this code of
conduct to publish information and give advice.
Among that advice, market participants are reminded that, "A
market participant should not attempt to improperly mislead its
counter-parties or dishonestly conceal material facts from them.
Market participants are reminded that activity of this kind may
34
amount to a criminal offense" — for example, under section 47.1 of
the Financial Services Act. That means that the SIB would refer
that to the appropriate national regulatory agency, much as we
would do under our exemption if we found evidence of fraud.
We would refer it to the Department of Justice or the appro-
priate State authority, and I think we would probably say some-
thing more than "this may amount to a criminal offense."
This code goes on — "A market participant should not attempt to
improperly manipulate the market. Activity of this kind may
amount to an offense," and again, to be referred to another author-
ity-
We would maintain manipulation authority within the CFTC
under this exemption, so I think that a careful reading of the dis-
tinctions between the two countries makes it pretty clear that we
haven't done anything particularly less-regulatory than in the U.K.
Mr. Allard. Ms. Bair.
Ms. Bair. I would have to disagree with that. I think that, not
only do antifraud provisions apply — it is true that the oil market
code of conduct provides regulatory guidance, but section 47 of the
Financial Services Act says that violations of the oil market code
of conduct could be deemed to be in violation of the Financial Serv-
ices Act.
The fact that the SIB— the enforcement structures such as the
SIB must refer criminal actions to another enforcement body. It's
just the way they are set up.
On the criminal side, we also have to — even things that we've re-
tained jurisdiction over — ^we've had to refer to the Justice Depart-
ment. We only had civil enforcement authority.
I would also add that not only do antifraud requirements apply
under the oil market code of conduct and the Financial Services
Act, but there are others that Brent Oil— 15-day Brent Oil con-
tracts are deemed investment contracts, which is the category that
also includes futures under the U.K.'s financial regulatory scheme,
and there were other requirements that — other regulations that
apply, too, with regard to disclosure, capital requirements — even
more than antifraud.
Mr. Allard. One thing I'd like to get back to, Ms. Bair, is, do
you agree that if a boilerroom operation was reported to your agen-
cy, that could be referred to the Department of Justice and referred
to the appropriate State authorities, and action could be taken
against that operation?
Ms. Bair. Well, it would depend on whether— since there's no —
assuming that it falls within the terms of the exemption, there
would be no violation of the Commodity Exchange Act, so we could
refer it to the Justice Department if we could show— you'd have to
show mail or water fraud, or you'd have to show State common law
fraud.
Mr. Allard. But if that would get pointed out to the CFTC, that
could be — I mean, there's no — I can't imagine just saying, "Well,
we're just going to ignore it. It doesn't fall under our jurisdiction."
If they would look for a suitable
Ms. Bair. I think, and I would hope we would do what we could
by giving it to — bringing it to the attention of other enforcement
35
bodies. I think the important point is, we are set up to prosecute
those types of cases, and we couldn't do it now
Mr. Allard. So it's a jurisdictional
Ms. Bair. Because we don't have jurisdiction anymore.
Mr. Allard. So it's a jurisdictional issue with you?
Ms. Bair. It's a jurisdictional issue. It's a matter of whether we
can fulfill our mandate to enforce the Commodity Exchange Act, in-
cluding antifraud provisions, to the types of transactions where we
traditionally have done so.
Mr. Allard. But what I've heard in testimony here is that the
Department of Justice and State laws can go aJiead and address
the problem with the boilerrooms. It doesn't necessarily have to be
the CFTC.
Ms. Bair. Again, that is not what the Justice Department is set
up to do. I don't know if we can get
Mr. Allard. No. That's — I mean
Ms. Bair. Yes. I understand.
Mr. Allard. They can do that?
Ms. Bair. Yes. They could do that.
Mr. Allard. So we're getting into sort of a jurisdictional percep-
tion. You'd like to see most of that power in CFTC, but if it's not
there, it is in the Justice Department or it's also under State juris-
diction in some cases.
Ms. Bair, I think that's a fundamental issue that this sub-
committee, as our oversight subcommittee, needs to look at and
deal with. Do you want a CFTC? Do you want us to enforce anti-
fraud laws as they apply to these types of scam operations, the way
we traditionally have done?
Mr. Allard. Yes.
Ms. Bair. There is always mail and wire fraud that you can
refer — you can try to plug that in and refer it to the Justice De-
partment or State common law fraud, but in terms of enforcement
bodies specifically set up to prosecute these types of fraudulent
transactions, that's what I thought the CFTC was supposed to do.
Mr. Allard. Yes. You know, we were wrestling with this legisla-
tion, as to how you go ahead and define all these hybrid instru-
ments and forwards and whatnots, and I don't want to disrupt the
international market.
I want to see us go ahead, but on the other hand, we don't want
to open the door for fraud or anj^hing, and I think a lot of us are
just waiting to see what's going to happen. I'd hate to see us jump
prematurely if there isn't any actual problem going on.
Mr. Albrecht.
Mr. Albrecht. Let me just make a couple of points, if I may.
One is that I think we have drawn this line in a responsible way.
It's difficult, of course, to draw the line as to what you permit and
what you don't permit. I don't think we're going to permit boiler-
rooms.
If things become full-fledged, run-of-the-mill boiler operations,
such as Commissioner Bair is talking about, I am convinced they
will run afoul of the exemption. I don't think you're going to find
those under the exemption.
If it turns out that I'm wrong, it would be very easy for the Com-
mission to address this issue — to revisit it, and change those lines.
36
What we have tried to do is draw a line around this market,
which permits the existing market to continue to exist. We tried to
draw a Kne around the market, such that it will not permit the
type of boilerroom operations that Commissioner Bair is talking
about to exist.
In truth, those two lines are probably not exactly the same line.
Whatever line you draw will probably exclude a few people from
the market whom you would like in the market. It also has the po-
tential of letting some activity go on that you prefer not.
I think we've examined this issue very carefully, and drawn the
line in a very responsible way. If, as you point out, experience
proves us wrong, we may want to expand that line, and we may
want to contract it.
Mr. Dial. I'd also like to make an observation in that regard. In
the first place, once again, in my opinion, what we're talking about
are forwards, and forwards have a history of nearly a century of
being used in commerce — domestic commerce and international
commerce.
Those that commented on this particular proposal did not make
any mention of problems with fraud, either in today's markets or
in markets that are past, so there is no strong evidence to indicate
that fraud is rampant in these energy contracts.
In addition to that, in enacting the 1992 act. Congress explicitly
authorized exemptions from all provisions of the act, except section
2(a)(1)(b), and simultaneously enacted a conforming amendment to
section 12(e)(2), explicitly acknowledging that State antifraud stat-
utes of general applicability would continue to apply to exempted
transactions, so
Mr. Allard. Mr. Chairman, I'm ready to wind up, if I could just
have one more question with Ms. Bair.
You had replied to one of the chairman's questions that the law
can apply when they're exempted. Did I understand that
Ms. Bair. Under the terms of this
Mr. Allard. Our understanding is correct. Then on your testi-
mony — you see, in your written testimony, you said, "Let me state
that I do not oppose in concept, some type of exemption from the
act from the Brent's crude oil contracts," which just all seems to
center around that, and it almost sounded to me like there was sort
of a contradiction here in the way you are responding in this, and
if you'd highlight that and-
Ms. Bair. No. I was referring to
Mr. Allard. Talk a little more.
Ms. Bair. I also go on to say, "But I think we should retain anti-
fraud and antimanipulation authority." Yes, I support an exemp-
tion from virtually — for the Brent Oil market for virtually all other
regulatory requirements of the Commodity Exchange Act.
And 4b, the general antifraud provision, and 4o, our antifraud
provision that applies to commodity pools, I think are very fun-
damental and basic, and we should not have banned an exemption
there.
Mr. Allard. So we can take
Ms. Bair. We have in this order.
Mr. Allard. All right.
37
Ms. Bair. And again, this order is not limited to the Brent Oil
market. It is much, broader than that.
Mr. Allard. Thank you.
Thank you, Mr. Chairman.
Mr. English. Thank you very much, Mr. Allard.
I also want to make a point. This, Commissioner Bair, if I'm not
mistaken, does, as you point out, goes beyond the Brent Oil deci-
sion.
Ms. Bair. Absolutely.
Mr. English. And this expands on the authority that existed
prior to the enactment of the reauthorization bill last year.
Ms. Bair. I think, to the extent that the intent behind that was
for us to use exemptive authority only to address the issues per-
taining to existing markets, yes. I think it goes beyond that.
With regard to — I know Chairman Albrecht may have a different
view — I think this order is much broader than the Brent Oil statu-
tory interp. I would note that the people who applied — the energy
group that applied for exemptive relief said in their application
that they need broader guidance, more comprehensive guidance in
meetings held with Commission staff — notes of which you have.
Again, they said it's not enough to just have the Brent statutory
interp. We need more relief that applies to a broader range of en-
ergy markets. There is no doubt in my mind that this order is sig-
nificantly broader than the Brent Oil statutory interp.
Mr. English. And certainly goes way beyond the status quo un-
derstanding that was reached between the members of the con-
ference last year.
Ms. Bair. Again, I was not privy to that. I can only go by what
was in the conference report.
My interpretation of the conference report was that — yes, you
wanted us to use this authority very judiciously and stick — yes,
provide additional clarification with regard to existing markets
where issues have arisen.
I think, clearly, with regard to the Brent Oil market, that is the
case, and it would have been appropriate and consistent with your
legislative intent, as I understood it — give relief to Brent Oil — but
we went beyond that.
Mr. English. As Mr. Allard pointed out, he was a member of the
conference, and if you recall last year, that was the understanding
that we reached — that there would not be — we would maintain the
status quo, and that was exactly what the purpose of these provi-
sions we put in the law were for,
Mr. Allard. Yes. Mr. Chairman, did Mr. Albrecht say that actu-
ally — your decision continued the status quo?
Mr. English. Well, he may say it, but that isn't what it does.
That's the whole point.
Mr. Allard. So there's a difference of agreement whether we
continued with status quo or
Mr. English. No. There isn't a difference of agreement at all. I
don't think you're going to find any lawyer that isn't sitting on that
Commission that's going to give you that opinion.
If I could continue on this — Mr. Albrecht, you also made the
statement that — with regard to the terms of the exemption — the
terms of the exemption that are granted to anyone who falls under
38
that category — if someone commits fraud, they are not violating the
terms of the exemption, are they?
Mr. Albrecht. Not by that act.
Mr. English. So the exemption that you have granted — a person
could go out and go so far as committing fraud, and they would not
be violating any terms of the exemption granted by the CFTC, and
the action of committing fraud would not be sufficient to have that
exemption revoked.
Mr. Albrecht. I think that if we found fraud
Mr. English. I'm just asking you, under the terms of the exemp-
tion. Under the terms of the exemption
Mr. Albrecht. Under the terms of the exemption, a person could
defraud a bank, defraud a customer, could lie to Congress, lie to
the CFTC — that would not violate the terms of the exemption. It
would violate other things, but it wouldn't violate the terms of the
exemption.
Mr. English. Also, I was curious — under the terms of the exemp-
tion, we also have broker dealers and, of course, futures commis-
sions merchants that are subject to the antifraud provisions of the
law on traditional futures contracts. Why is there a different treat-
ment in this area? Why shouldn't antifraud apply to broker dealers
and futures commission merchants who are in this area, as op-
posed to those who are dealing with the traditional futures con-
tracts?
Mr. Albrecht, It would apply, of course, to their activities deal-
ing with customers in traditional futures contracts.
I've tried to get this in a couple of times, and I think it would
help if I could do it sooner rather than later because
Mr. English. I'd like for you — if you would answer my question,
please. The question I asked you is, why is there a different appli-
cation to broker dealers and futures commission merchants under
traditional futures contracts, as opposed to under these contracts?
Mr. Albrecht. For the very reasons that we gave the exemption.
This is a commercial-to-commercial market. It's a principals mar-
ket.
It's not the general public. It's a fairly closed group of a fairly
small number of people that know each other
Mr. English. How do you know that?
Mr. Albrecht. Know the credit worthiness of one another, and
there's no reason to subject somebody to a particular law, just be-
cause he happens to be an FCM, for that particular type of trans-
action.
If it spilled over in any way to their regulated activity, it would
be subject to our law. In any event, we still have the authority to
use our risk assessment to determine whether there were any fi-
nancial integrity issues raised by this activity. They still have that
authority.
Mr. English. Now as I understand it, the CFTC supposedly still
has a study underway to determine exactly what we're talking
about in the derivative markets, and what is involved in the deriv-
ative markets, and every bit of testimony we've received — every in-
dication we've received from people who have been involved in this,
particularly within the General Accounting Office — no one knows
39
for sure, so I'm intrigued, Mr. Albrecht, with the finding that you
have.
This is a fairiy small group of people, all of whom know each
other, all of whom are financially — I don't know what that means —
what was the term you used? Financially secure? Financially well
off? What does that mean?
Mr. Albrecht. I'm not — that's not in the order I used it. I used
it rather imprecisely. We have specific net worth and asset tests
and so forth in the exemption.
Mr. English. But how do you know that?
Mr. Albrecht. Well, of course, one doesn't know exactly in every
transaction
Mr. English. So you, with regard to the individuals that will be
involved in this market — and as Commissioner Bair pointed out,
this is not just the Brent Oil folks, this is an energy exemption —
and you're telling me that you personally know who all these indi-
viduals are, you personally are aware of the transactions that they
carry out, and personally aware of their financial situation, and
you know that this is not going to have an impact on the public,
is that right?
Mr. Albrecht. Well, of course, I don't know that.
Mr. English. Well then, why did you make that statement?
Mr. Albrecht. I don't believe that I said that I know these peo-
ple.
Mr. English. Well, who does?
Mr. Albrecht. First of all, if they do not meet these standards,
they have violated the terms of the exemption and they are subject
to our oversight.
Mr. English. Who is canying out the investigation as to wheth-
er or not they've met the terms of the exemption?
Mr, Albrecht. Somebody would have to complain to us, and we
would carry out the investigation. We would have to have people
carry out the investigation
Mr. English. Only after the fact, do you determine whether or
not someone was truly eligible under whatever it is you have in
your mind — the criteria the people should have to meet this exemp-
tion?
It's an after-the-fact determination as to whether or not they
were exempt, but before that fact, unless someone brings it to your
attention, unless someone complains, unless there is some reason,
which I suppose would have to be a complaint for an investigation
by the CFTC, and there would have to be a finding, I suppose, be-
fore you carried out that investigation, then you have no idea who's
getting this exemption, you have no knowledge with regard to their
financial circumstances, and you know absolutely nothing about
the people that are being covered by a blanket exemption, which
takes on, quite fi'ankly, the characteristics of an exclusion rather
than an exemption.
Mr. Albrecht, The fact of the matter is that — one, virtually
every time fraud occurs, we find out about it after it has occurred,
and we go in and investigate if we have a complaint
Mr. English. Well, Mr.
Mr. Albrecht. May I please finish?
40
Mr. English. Well, the thing that troubles me is you're not an-
swering my question.
The question I asked you, Mr. Albrecht, is how you responded to
my question, with regard to the differences as to why someone who
is a broker/dealer or a futures commission merchant should be re-
quired to be under that act if they're trading under traditional fu-
tures contracts — but in this case, they should not.
What I was looking for was the justification as to what is the jus-
tification for making this difference between the two under — and
granting one an exemption, and not the other, and you responded
by saying, "This is a very small number of people. These are people
who are well-known with each other. They're financially secure
people."
Then I asked you, "Well, then do you personally know them?"
You said you do not know them personally.
Then I tried to determine — "Well, what is" — ^what do you know
about them, and evidently you don't know anything about them, so
you don't know whether it's a small group of people, a big group
of people — you don't know whether they're broke on their tail
today, but you've granted the exemption under the illusion, I sup-
pose, that these are the kind of folks that deal in this market — be-
cause somebody told you so.
Is that all you know about it? Is that right, Mr. Albrecht? Is that
the only knowledge that you have — it's because somebody told you
that's the way it was?
Mr. Albrecht. We have representations in the applications
about the nature of this market. We have reason to believe those
representations are accurate.
Mr. English. Well, who are these people? That's what I'm trying
to find out. How do you determine the credibility of these people?
Mr. Albrecht. I think they're listed in the energy exemption.
The names are there.
The big oil companies, the big gasoline companies are the major
people that
Mr. English. Are they the only ones trading in this area?
Mr. Albrecht. They are the major people that are in this mar-
ket today.
Mr. English. How do you know that?
Mr. Albrecht. I have been told that.
Mr. English. Who told you that?
Mr. Albrecht. We were told that in comment letters, we were
told that in
Mr. English. You got 12 comment letters, I believe you said.
Mr. Albrecht. We were told that in comment letters, we were
told that by the people that applied for the exemption.
Mr. English. So the people who want to be exempt are the peo-
ple who have given you the information that you're relying on to
base this decision before the3^re ever exempt. Is that right?
Mr. Albrecht. And as I've indicated, if people do not adhere to
the terms of the exemption, then they are subject to our jurisdic-
tion.
Mr. English. So they can go out and commit fraud, and not vio-
late the terms of the exemption, they can — as long as they don't get
caught, they can continue the exemption.
41
What are the terms of the exemption? In what possible way could
they violate the terms of the exemption?
Mr. Albrecht. If a firm does not meet the standards set forth
in that exemption
Mr. English. What are the standards?
Mr. Albrecht. The standards are: They have to be commercials,
they have to be involved in the business in one way or another,
they have to assume risk other than price risk — they have to meet
one of the various standards of being an appropriate person.
Mr. English. An appropriate person?
Mr. Albrecht. Appropriate person. That's the language that I
believe is in the legislation.
Mr. English. So as long as they meet that general criteria — how
in the world could they violate that criteria? I mean, how could
they not be exempt? That's a better question.
Mr. Albrecht. If you were in that market, you would violate it.
I don't think you're in the terms of the — perhaps I don't
Mr. English. I don't know that I would, because you'd have to
catch me first, Mr. Albrecht, and I don't know that you can catch
me.
Tell me about the detection system that you have set up to go
in and identify those people who are violating the agreement. What
kind of detection system does the CFTC have set up to determine
whether or not someone is, in fact, violating the agreement?
Mr. Albrecht. We would have to get complaints.
Mr. English. You'd have to get what?
Mr. Albrecht. Complaints.
Mr. English. So if nobody complains, it's a blind eye from the
CFTC — "You guys go do whatever you want to. Commit fraud, do
anything you want to, just don't tell us about it" — is that right?
Mr. Ajlbrecht. That's the way we catch all fraud — almost all off-
exchange fraud. We have monitoring systems on exchanges. We
don't have monitoring systems elsewhere.
Mr. English. But in this case
Mr. Albrecht. We have 570 people-
Mr. English. In this case, Mr. Albrecht, there's a difference. In
the other cases you're mentioning, we have laws, we have rules, we
have statutes, and we have a regulatory body that has the respon-
sibility to deal with that.
In this case, you've exempted them. If they're exempt, the/re ex-
empt. If you get complaints of fraud, you've exempted them from
fraud.
How in the world can you take any action against someone you
have exempted from fraud? They can go out and just cheat people
blind, and there's not a blooming thing you can do about it.
The very agency that we have put our trust into — if you can't
deal with fraud, Mr. Albrecht, there is no reason for you to be here.
Mr. Albrecht. We deal with — we would
Mr. English. By the way, when does your term expire, Mr.
Albrecht?
Mr. Albrecht. It has expired.
Mr. English. It has? So you're a lameduck.
Mr. Albrecht. I'm very lame.
Mr. English. And this was a lameduck decision.
42
Mr. Albrecht. This was not a lameduck decision. I guess it
would have been easier to duck this decision, but I made it because
I thought we needed to keep moving.
Markets don't wait for Presidents to make appointments. Mar-
kets continue to move. We needed to do something.
If I could just say
Mr. English. Well, let me just say, I wish to God you had. I
think the public — this country would have been better off if you
had.
Mr. Albrecht. We regulate this the same way we regulate fraud
in forward markets. We have no jurisdiction over forward markets.
The only way we would find out if the law was being violated is
if somebody were to tell us, "Hey, this isn't really a forward mar-
ket," then we would take a look at it.
Mr. English. But in this particular case, you've been handed
special authority by the Congress — special authority to maintain
the status quo until the Congress can make a decision — until we
can make a judgment as to how to deal with these kinds of instru-
ments with the derivatives — only to maintain the status quo, not
to produce an end.
But you saw fit to take that responsibility beyond the status quo,
and now you tell us that you have no way of determining whether
or not the criteria that you have set out to qualify for the exemp-
tion is even being met, isn't that right?
Mr. Albrecht. I'm sorry. The question specifically is?
Mr. English. The question is specifically, you have no way of de-
termining whether or not the criteria that you have set out under
the very special authority that has been granted by the Congress
to deal with some very special problems — you have no way of deter-
mining whether or not that criteria is being met.
You cannot assure the public, you cannot assure the Congress,
you cannot assure this Nation that, in fact, the criteria that you
have set out for this exemption from fi'aud is being met.
Mr. Albrecht. We can tell, anj^ime we look at a situation, as
to whether it is being met, so we do have a way.
Mr. English. How can you do that?
Mr. Albrecht. We look at the participants, and we see if they
meet the criteria
Mr. English. You don't even know who they are, Mr. Albrecht.
We don't know who they are.
Mr. Albrecht. If we had a situation to look at, we could do
that — we would do that. We would look at this market and say,
"Who are the participants? What are they doing?"
Anytime we want, we can go in and look at a market — of course,
we can do that.
Mr. English. You have
Mr. Albrecht. We would if we had any reason to believe that
we should.
Mr. English. If you had any reason to believe that you should.
Mr. Albrecht. Which is much the way we conduct all of our in-
vestigations right now.
Mr. English. You have no way of knowing — when you grant that
exemption, you're not granting it to individuals, you're blanket-ex-
43
empting. Anyone and everyone who's involved in this business is
exempt from fraud.
Isn't that what it says?
Mr. Albrecht. I don't beUeve that's what it says at all.
Mr. English. Commissioner Bair, is that your interpretation?
Ms. Bair. Again, my interpretation of the exemptive order is, if
it meets the terms of the exemption, yes. It's completely off our
Mr. English. And we'd have no way of knowing what the terms
of the — whether they're meeting the terms of the exemption or not,
do we?
Ms. Bair. I think that's a good point. I think — and I believe that
was specifically referenced in the legislation — that perhaps there
should be some monitoring system to determine — not only just this
area, but swaps and hybrids as well — whether the terms of the ex-
emption are being met. That is not in existence now, that I know
of.
Mr. English. So under the ruling by the Commission — Mr.
Albrecht and Mr. Dial — they have decided that we shouldn't do
that. They've made the decision under this ruling that we \yill have
no check whatsoever to determine whether or not the individuals,
who are being exempted, meet the criteria under the exemption.
We have no way of determining whether or not the people that
we are providing this trust are the biggest thieves in the world —
maybe some of the biggest thieves in the world — and we're turning
them loose — loose from all fraud requirements of the CFTC — of the
very regulatory body that is supposed to be looking out for the pub-
lic. Is that correct. Commissioner Bair?
Ms. Bair. I don't want to speak for my colleagues, but that is
Mr. English. I'm just asking your opinion.
Ms. Bair. Yes. In my opinion, that is what has happened — that
it is a very broad exemption, and if folks — whoever wants to — has
the creative mind to do it, can meet the terms of the exemptions.
I think it's very easy to do.
They are exempt from everything, including our antifraud re-
quirements, and we can't do an3rthing about it.
Mr. English. Let me go back then, Mr. Albrecht. Do you have
any way of identifjdng who the individuals are that you're granting
this exemption to?
Mr. Albrecht. We know who some of them are. We don't know
who all of them are.
Mr. English. Can you even say you know who most of them are?
Mr. Albrecht. Personally, no.
Mr. English. Does the CFTC know who most of them are?
Mr. Albrecht. Probably not.
Mr. English. So you don't know who the individuals are that
we're granting the exemption to. Let me take the next step then —
do you have any mechanism, as was recommended in the legisla-
tion — do you have any mechanism to determine and see if, in fact,
the people who are receiving these exemptions meet the criteria?
Mr. Albrecht. We have two mechanisms. One is that
Mr. English. I'm talking about before the exemption is granted.
Mr. Albrecht. Well, the primary mechanism, of course, is to re-
spond to allegations that something wrong is going on. I would ex-
pect that the Commission would continue to keep an eye on this
44
market— to revisit it, to look at it, to make sure the terms of the
exemption are being met,
Mr. English. Is there any mechanism that you have set up in
this ruHng to do that?
Mr. Albrecht. We have not done that.
Mr. English. So there is no assurance to the pubHc that that cri-
teria is being checked. It's not being checked before the exemption's
given. There's no mechanism in the criteria to check it afterwards.
The only thing that the public can hope for is that if we have
any people who are committing fraud, that those people — somebody
blows the whistle on them at some time. That's the best we can
hope for.
Mr. Albrecht. That will happen.
Mr. English. That will happen?
Mr. Albrecht. If there is any serious amount of fraud, people
will blow the whistle.
Mr. English. If there is any serious amount of fraud.
Mr. Albrecht. There can be an isolated instance where someone
gets cheated out of a nickel or a dime, but I mean, if there is
Mr. English. Well, we're talking about billions and billions of
dollars being traded here, Mr. Albrecht. We're not talking about
nickels and dimes, we're talking about billions on international
markets that, according to the president of the Federal Reserve in
New York, can have an impact on the very economy of this country.
Isn't that correct?
Mr. Albrecht. If there's any fraud of any significance, it will be
found out about. The person who is defrauded will complain.
Mr. English. Mr. Albrecht, I'm going to tell you, that's a very
naive way of thinking. We have crimes committed in this country
that are not reported.
We have a lot of crime, and a lot of people that are victims of
crime that are not reported, and it may go on for some time before
it's reported, much less the individuals being caught.
If you're simply assuming that every crime that is committed is
going to be reported to the CFTC, I think you have a very naive
view of the world. It doesn't happen that way in real life.
If you aren't aggressively — if that is the case, why in the world
do we bother to have people looking at the futures exchanges? Why
don't we just sit back and say, "Well, if there's a problem some-
place, somebody will give us a call" — why did we bother to have the
FBI, and of course, that raises the question — maybe we now are
seeing it— why it took the FBI and the U.S. Attorney in Chicago
to put undercover people in place.
It brings us down to the real question of "What in God's name
is the CFTC all about?" If it's not— if we can't even count on the
CFTC to protect the public from fraud, if we can't depend on the
CFTC not to give away the store, from the standpoint of giving
blanket — not exemptions, exclusions — that's an outrage. I mean,
you're not worth your salt if you can't do that, Mr. Albrecht.
I have defended the CFTC for the last 4 years. I fought for in-
creasing the budgets of the CFTC for the past 4 years. I've fought
to prevent incursions on the jurisdiction of the CFTC for the last
4 years, but I have to tell you, today I'm asking myself, "Why, in
God's name, did I do it?"
45
I think your actions have raised serious questions as to whether
or not the CFTC can be entrusted with this responsibiHty. I can
certainly agree and understand differences of opinion, but when it
comes down to opening the door to fraud, that's simply going too
far. That's not deregulation, that's just blatant irresponsibility.
I would encourage the Commissioners to reconsider their decision
in this area. I would encourage the CFTC to consider, any time
they're granting any exemption, a provision in which any crimes of
fraud or manipulation — that that be applied in general and not just
under the specific futures provisions of the CFTC — that the CFTC
retain the right, regardless of whether on any responsibility that
they might have, regardless of whether it is or is not defined a fu-
tures contract, to act in dealing with fraud and manipulation.
I would encourage the CFTC to look at private rights of action.
If you want somebody to come tell you about fraud, that's the way
to do it, Mr. Albrecht — give them that right — give them some kind
of recourse.
And to simply dump it back and assume that the States are
going to be able to handle this is just an outrage, when you've
taken away part of the authority that the States have had.
I have to say, in the 18 years that I've been in Congress, this is
the most irresponsible decision I've come across.
Mr. Allard, do you have any other statements or comments you'd
like to make?
Mr. Allard, No, Mr. Chairman.
Mr. English. I said, I urge the Commission to reconsider this de-
cision.
With that, we'll recess, subject to the call of the Chair.
[Whereupon, at 12:10 p.m., the subcommittee adjourned, to re-
convene, subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]
46
statement of Dr. William P. Albrecht
Acting Chairman
Commodity Futures Trading Commission
Before the Subcommittee on Conservation, Credit
and Rural Development of the
House Committee on Agriculture
April 28, 1993
Good Morning, Mr. Chairman and members of the Committee. Six
months ago today, the President signed into law the Futures Trading
Practices Act of 1992 ("1992 Act") . Since then the Commission has
been working diligently to implement the statutory reforms and new
authorities which you and this Committee helped originate. For
your information, I have attached a summary of actions the
Commission has taken in response to the 1992 Act.
Today, I welcome this opportunity to discuss one of our most
recent steps: exempting from regulation under the Commodity
Exchange Act ("CEA") certain contracts for the deferred purchase or
sale of specified energy products.
Statutory Background
Prior to the 1992 Act, any instrument classified as a futures
contract could lawfully trade only on a CFTC-designated exchange.
Other instruments such as forward contracts were completely
excluded from CFTC authority. This all or nothing approach worked
fairly well for more than fifty years. However in recent years we
saw the advent of new financial and commodity products which
47
2
contain both futures and non-futures elements. Clearly, the
financial and commodity markets were evolving in ways never
contemplated when the CEA was originally drafted. The Commission
found itself spending more and more time studying these new off-
exchange instruments, trying to fit them into the right statutory
pigeon hole. The CEA's inflexible requirements also impeded the
introduction of economically useful new products which might fall
on the futures side of the line, but were not suited for exchange
trading because of contract size, limited interest or other
factors.
After studying these issues, Congress wisely recognized the
need to give the Commission greater flexibility in dealing with
innovative products. Thus, the 1992 Act added Section 4(c) to the
CEA, This provision gave the CFTC authority to exempt any
agreement from the exchange-trading and most other requirements of
the CEA contingent upon certain conditions. Those conditions
include: a Commission determination that the exemption is in the
public interest; the agreement is between appropriate persons (such
as institutional participants) ; and the agreement does not have a
material adverse effect on the ability of the Commission or any
exchange to discharge its regulatory or self -regulatory duties.
The Conference Committee explained that the Commission was granted
this exemptive authority in order to provide "certainty and
stability to existing and emerging markets so that financial
innovation and market development can proceed in an effective and
competitive manner." The Conferees specifically stated that they
48
3
"expect and strongly encourage the Commission to use its new
exemptive powers promptly upon enactment [of the 1992 Act] in four
areas where significant legal uncertainty have arisen...." These
areas included swaps and hybrids, where the Commission acted in
January, and forwards, which are the subject of the Commission's
recent energy contract exemption.
The Energy Contracts
The classification of energy transactions as futures or
forwards had become a crucial issue in 1990, when one court found
certain transactions in the Brent crude oil market to be futures
contracts. See Transnor (Bermuda) Limited v. BP North America
Petroleum . 738 F. Supp. 1472 (S.D.N.Y.). These transactions had
never before been considered futures contracts. Now, they could be
void as off -exchange futures contracts. This decision stunned the
international energy markets. Technically, this aspect of the case
applied only to Brent market transactions. However, the facts in
Transnor involved individuals, firms and transactions on four
continents and the language of the decision brought into question
trading practices throughout the international and domestic energy
markets. Clearly, the sophisticated international energy and
trading firms that made up this market should not be permitted to
walk away from losing transactions by simply declaring their
contracts void as off-exchange futures contracts.
The Commission's response was to issue a statutory
interpretation stating that it did not view these transactions as
49
4
futures, but rather as cash forward contracts, and thus excluded
from regulation under the CEA. Unfortunately, this action did not
completely resolve the problem. Legal uncertainty continued and
was reportedly sufficient to deter some international firms from
entering into transactions with U.S. firms.
Congress was aware of this and specifically mentioned the
Transnor case in the Conference Report on the 1992 Act. The
Conferees encouraged the Commission to review the situation to
determine whether exemptive or other action should be taken. The
Conferees noted the international scope of these markets and also
that, since foreign participants were free of restraints imposed by
the CEA, competitive disadvantages for the U.S. could result.
Commission Response
Last November — just three weeks after the 1992 Act became
law — the Commission received an application for exemptive relief
for these contracts. In January, in response to this application,
we published a proposal to exempt certain contracts for the
deferred purchase or sale of specified energy products from
Commission jurisdiction. The Commission limited its proposal to
existing practices in the energy markets, as described in the
application. Since the Commission was not regulating this market,
the proposal essentially maintained our existing jurisdiction.
The Commission received sixteen comments on the proposal, all
but one of the which generally supported the proposed exemption.
After carefully considering the views of the commenters, the
50
5
Commission granted the exemption, limiting its order to those
general types of commercial participants identified in the
application. The Commission made some technical changes in the
final exemption, such as including "condensates" as an underlying
commodity, and tightened the exemption to eliminate provisions that
would have allowed qualifying firms to act as fiduciaries on behalf
of customers. Beyond that, the exemption was largely adopted as
originally proposed.
I believe the Commission made the right decision. The
exemption covers large commercial participants in of f -exchange,
energy based transactions. These transactions compose a large
ongoing market for energy products — a market that is vitally
important to U.S. and international commerce — that has existed
for aany years, continually growing in size, importance and
complexity. The Commission has never regulated nor sought to
regulate this market. I am aware of no reason sufficient to
justify Commission regulation now. Indeed, this market, its
transactions and participants are clearly within the scope Congress
intended for the exercise of the Commission's new exempt ive
authority.
Section 4b of the CEA
Questions have arisen, however, as to whether the Commission
should have reserved the applicability of the anti-fraud provisions
of section 4b of the CEA in granting this exemption. We
specifically requested comment on this issue in the Notice of
51
6
Proposed Rulemaking. No coimnenter advanced any arguments
supporting Commission retention of anti-fraud jurisdiction and most
of the commenters affirmatively opposed it. They cited the
commercial nature of these transactions and the fact that the
proposal was limited to commercial participants and other
"appropriate persons" — sophisticated entities quite able to look
out for their own interests. A majority of the Commission agreed.
They voted not to retain Section 4b to whatever extent it might
apply to these transactions.
Some have urged that the Commission should have retained
section 4b, as it did in the case of its swaps exemption. Indeed,
I have even heard it said that the Commission cannot legally exempt
these energy contracts from section 4b. While one may reasonably
disagree with the merits of our decision, as a natter of law the
exemption is clearly within the CFTC's statutory authority: the
exemptive power runs to all provisions of the CEA with the sole
exception of section 2(a)(1)(B).
As a matter of policy, I fully support the decision not to
apply 4b to these exempt energy transactions. One of the most
valuable aspects of our exemptive authority is that it allows the
Commission to proceed on a case-by-case basis — an exemption for
one product can retain some regulatory controls while another
exemption can retain more, or none at all.
In the case of swaps, for example, the Commission did agree to
reserve section 4b, as suggested by several of the commenters on
that proposal. I think that too was the right decision. Section
52
7
4b covers fraud committed by one person acting for or on behalf of
another: an agent acting for its principal, if you will. The swaps
exemption specifically permits some eligible participants to act on
behalf of other eligible participants in entering into swaps
transactions. Thus, the principal-agent aspect of section 4b could
have relevance if a given swap agreement was found to be a futures
contract.
This is not the case with the energy exemption. These energy
contracts are entered into between principals. The exemption
applies only to "bilateral contracts between two parties acting as
principals", thus it does not allow one participant in this market
to act for or on behalf of another. Accordingly, any relevance of
section 4b on its face to these transactions is highly
questionable.
Furthermore, in the Commission's 1990 statutory
interpretation, we took the position that generally these were not
futures contracts, but rather forward contracts. By law, section
4b does not cover forward contracts. Thus, any attempt to actually
take an enforcement action based on 4b would face substantial
jurisdictional hurdles.
In these circumstances, rather than providing a potential
benefit, retaining section 4b would create legal uncertainty.
Having gone to great lengths to assure foreign energy firms that
they may engage in normal pre- Transnor business practices with U.S.
firms, the presence of 4b may say to some that the futures issue is
not over. To some of these firms the presence of 4b would indicate
53
8
that the CFTC is exerting some jurisdiction over them and that more
may follow. Further, it would inject the illusion of Commission
supervision into a market where there is none. In that regard,
some may take comfort from the coverage of 4b, but it would be cold
comfort indeed without the benefits of any ongoing regulation.
After all, the Commission just does not have the resources
necessary to adequately regulate these markets. In short, the
benefits of extending the coverage of 4b to this market are not
apparent.
While it is correct that the Commission has exempted these
transactions from Commission regulation generally, and in
particular from Section 4b of the CEA, that does not mean that
these transactions are above the law, or that fraud is somehow
permitted. While problems can occur, as evidenced by Iransnor's
refusal to pay and take delivery of Brent oil, these are generally
private contractual disputes that typically do not involve public
concern about fraud or market integrity. To the extent there are
concerns about the ability of these firms to perform their
contractual obligations, these large commercial institutions do not
appear to need or desire the assistance of the Commission to police
their market to assure performance of contractual obligations.
Nevertheless, to the extent this activity occurs in firms related
to a futures commission merchant ("FCM"), the Commission can use
its risk assessment authority to monitor risk to the FCM.
While fraud remains a possibility, even in a market consisting
of sophisticated large commercial firms, existing civil and
54
9
criminal remedies exist and the extension of the Commission's law
enforcement authority into this market appears unwarranted. The
participants have not found existing remedies insufficient, nor
have they asked the Commission for additional protection.
Finally, I would point out that should the practices within
this market change to the detriment of its participants, or the
public, or should these transactions take on more characteristics
of futures contracts, the Commission can always revisit both the
wisdom and the scope of its exemption. For instance, we could
tighten the restrictions on who can engage in these transactions.
Or, if unforseen events warrant, we could extend 4b coverage to
this market after all. Unlike prior law, our exemptive authority
under section 4(c) is a flexible statutory tool which can quickly
be used to accommodate change. In this regard, I would like to
conclude with a few words about the changing marketplace.
Section 4 (c) and the Changing Marketplace
As I have noted, Congress gave the CFTC broad exemptive powers
as a means of providing certainty and stability to existing and
emerging markets. Congress understood that 1992 is not 1922 or
even 1972. The regulatory schemes of the past are being stretched
by technological changes almost on a daily basis. New statutory
approaches and tailored regulations are more appropriate than a
single set of rules for diverse instruments and markets.
Furthermore, the institutional traders that now dominate the
financial markets simply do not need as much protection as
55
10
individual customers.
Some of our foreign competitors have recognized this. In the
U.K., for example, firms dealing with sophisticated investors are
subject to less stringent rules — among other things, less
elaborate risk disclosures and the ability to have customers decide
whether their funds will be segregated. This produces cost savings
for both government and those regulated.
Unless we in the U.S. also recognize these regulatory
realities, we will inevitably lose the battle of international
competitiveness in financial services. The CFTC is keenly aware of
these issues and has done a lot in recent years to address them.
New section 4(c) now gives us the opportunity to do more and we
hope to do so as Congress intended. Mr. Chairman, we trust we will
have your support as we proceed.
I will be happy to answer any questions you may have.
i
56
COMMODITY FUTURES TRADING
COMMISSION
Exemption for Certain Contracts
Involving Energy Products
AGENCY: Commodity Futures Trading
Commission.
ACTION: Final order.
SUMMARY: In response to an application
for exemptive relief, the Commodity
Futures Trading Commission
("Commission") proposed to issue an
order exempting from regulation under
the Commodity Exchange Act, 7 U.S.C.
1 et seq. ("Act"), certain contracts for
the deferred purchase or sale of certain
specified energy products. 58 FR 6250
(January 27, 1993). This exemptive
order is being issued pursuant to the
exemptive authority recently granted to
the Commission In the Futures Trading
Practices Act of 1992. The
Commission's Order is intended to
provide greater legal certainty regarding
trading in these products.
EFFECTIVE DATE: May 20, 1993.
FOR FURTHER INFORMATION CONTACT:
Paul M. Architzel, Chief Counsel or
Joseph B. Storer, Economist, Division of
Economic Analysis, Telephone: (202)
254-6990 or 254-7303, respectively, or
David R. Merrill, Deputy General
Counsel, Office of the Genbral Counsel,
Telephone: (202) 254-9880, Commodity
57
federal Register / Vol. 58, No. 74 / 1 ucsaay. ApiU 10, lyyj / Notices
^i^oi
Futur«s Trading Commission, 2033 K
Street. ^4W.. Washington. DC 20581.
SOPPtCMENTARY MFOfttUTION:
I. Background
A. Statutory Framework
As the Commission noted in the
Notice Proposing Issuance of an Order,
58 FR at 6250. section 2(a)(1)(A) of the
Act grants the Commission exclusive
jurisdiction over accounts, agreements
and transactions commonly known as
options, and transactions involving
contracts of sale of a commodity for
future delivery traded or executed on a
contract market or any other board of
trade, exchange, or market. 7 U.S.C. 2.
The Act and Commission rules require
that transactions in commodity Futures
contracts and commodity option
contracts, with narrowly deHned
exceptions, occur on or subject to the
rules of contract markets designated by
the Commission.'
The recently enacted Futures Trading
Practices Act of 1992. Public Law No.
102-564 {"1992 Act'*), added new
subsections (c) and (d) to section 4 of
the Act. New section 4(c)(1) authorizes
the Commission, by rule, regulation, or
order, to exempt any agreement,
contract or transaction, or class thereof,
from tae exchange-trading requirements
of section 4(a) or any other requirement
of the Act other than section 2(a)(1)(B).*
New section 4(c)(2) provides that the
Commission may not grant an
exemption ftom the exchange-trading
requirement of the Act unless, inter alia.
' SflcUoQB «(*). 4c(bl and 4c(c) of Iho Ad. 7 U S C
6(a). 6c(b). BdcJ. Sechon 4(a) of Ihfl CEA
specifically provfdes. inter alio, thai It Is unlawful
lo eotar lolo ■ commodity futures contraci thai is
oot made oo or sub^ to the mlu of a tXMxd of
trada which hu bean daaignaled by lb*
CommissloQ as « "cootr*cl mariet" tor such
commodity. 7 US C a(a). This prohlNlioa does not
apply to futures coolracts made oo or subject lo the
rules of a foreign board of trade, exchange or
markrt 7 US C ft(a).
'SpeciflcAlly. wction ♦{cMl). 7 U S C e(cKl),
provides:
"lo order to promote responsible economic or
financial lonovalloD and fall competition, the
Commlsiioo by rule, regulatloo. or order, after
notice and opportunity for bearing, may (oo its own
Initiative or oo application of any pervoo, Including
any board of trade designated as a cootrvct market
tot transactions for Future delivery in any
commodity under secUoD 5 of this Act)exempl any
agreement, contract, or transadion (or class thereof)
that Is otherwise subject to subsectloo (a) (iixJudlng
any person or class of persons offerinft, eolering
into, rendering advice or rendering other services
with respect to, the agreement, contract, or
transactioD), either unconditionally or oo slated
lenns or conditions or for stated periods and either
retroactively or prospectively, or both, bxtm any of
the requlremenis of suhsaclioo (a), or from any
other provtsloo of this Act (except section
2(aXl)(BH. tf the Commission determines thai the
exemption would be consistent with the public
tntereat."
the agreement, contract or transaction
will be entered into solely between
"appropriate persons", a term defined
in new section 4(c)(3). ^ In granting
exemptions, the CommissioD must also
determine specifically that the exchange
trading requirements of section 4(a)
should not be applied, that the
agreement, contract or transaction in
question will not have a material
adverse effeci on the ability of the
Commission or any contract market to
discharge its regulatory or self-
rogulatory duties under the Act and that
the exemption would be consistent with
the public interest and the purposes of
the Act.*
' SecUoD 4(c). 7 U S.C e(cH3). provides that:
"* * * the term 'approprlale person' shall be
limited lo the following pardons or classes thereof:
"(A) A bank or trust company (acting in an
individual or Tiduciary capably).
"(B) A savings association.
"(C) An Insurance company.
"(D) An invesimenl company subbed to
regulation under ihe Inveslmenl Company Act of
1940(15 use 80*-l etseq).
"(E) A commodity pool formed or operated by a
porvin subject lo regulation under this Act.
"(F) A corporalion. pa;tnership. proprietorship.
organiLfition. trust, or other business enlily with a
net worth exceoding Sl,(XX).0O0 or total as»els
exceeding S5.000,000. or Ihe obligations of which
under the agreemeat, contract or Iraasactlon are
guaranteed oi 'Otherwise supported by a lettor of
credit or keepwell support, or other agreement by
any such entity or by an entity referred to io
subparagraph (A|. (B). (C). (H). (I), or (K) of this
paragraph.
"(C) An employee tMnefil plan with assets
exceeding $1,000,000 or whose investment
decisions are made by a bank, trust company,
insurance company, inveslmenl adviser registered
under the Investment Advisers Ad of 1940 (IS
use SOft-1 el seq.). or • commoditv trading
advisor subject to regulalioo under this Ad.
"(H) Any governmental enlily (including the
United Stales, any stale, or any foreign govnrmnent)
or political subdivision thereof, or any
mullinational or supranational entity or any
Instnimeotality, agency, or department of any of the
foregoing.
"(I) A tiroker- dealer subfecl lo regulation undv
the SecuriUes Exchange Ad of 19J4 (15 US C 78a
et seq ) Ktingon Its own l)ehairor oo tmhalfof
another appropriate person.
"(J) A fut\ires commission merchant, floor broker,
or floor trader rutted to regulalioo under this Act
•ding oo Its own behalf or on behalf of another
appropriate person."
* Specifically, section 4(c)(2). 7 U S.C 6(c)(2).
suias:
"The Commission shall oot grant any exemption
■ * * from any of the requirements of sub&edkia
(a) unless the Commission determines that (A) the
requirement should not be applied to the
■greemenL conlrad, or transadion for which lh«
exemptloo Is sought and thai the exemption would
be consistent with the public Interest and Ihe
purpoees of this Act, and (B) the agreement,
contract or transadion —
"(i) WiU be entered Into solely t>elween
appropriate persons: and
"(ii) Will Dol have a material adverse effed oo the
ability of the Commission or any contrad market to
discharge its regulatory or self-regulatory duties
under this Act"
As Is frequently the case when Congress giants a
regulatory agency authority to ad in a manner
B. The Proposed Order
The Commission, on January 27.
1993. published for public comment tho
proposed order. The Commission
proposed this order in response to an
application for exemptive relief
("application") filed oy a group of
entities (the "Energy Group") which
represented that each is a producer,
processor and/or merchandiser of crude
oil, natural gas and/or other crude oil or
natural gas product, or is otherwise
engaged in a commercial business in
these commodities.'
The application, submitted pursuant
to Section 4(c) of the Act. is for an order
exempting ^m regulation transactions
for the purchase and sale of certain
energy products through contracts that
meet specified criteria. As noted In the
Notice Proposing Issuance of an Order.
the applicants based their request for an
exemption both on the nature of the
participants in, and on various
representations regarding the usage and
form of, these transactions.*
consistent with "the public interact sod the
purposes of* its enabling statute, little statutory
etaboralion Is given As commonly uodertlood.
however, an agency, such as the Commlssloo, is to
apply this standard against the template of Its
regulatory scheme. In this regard, the Conference
Report states that the "nublic Interesl" under
section 4(c] includes "Ute national public InteresU
noted lo the jAd). the prevention of fraud and the
preservation of the financial int(>grlly of markets. aJ
well as the promotion of responsible economic or
finandal innovation and fair competition." H R.
Rep No. 97&, 102d Cong.. 2d 5^ess. 7a The
Conference Report goes on to s.ete that "(t|he
Conferees Intend (or this reference lo the 'purposes
of Ihe Ad' to underscore their expectation thai the
Commission will assess the impact of a proposed
exemption on the maintenance of the Integrity and
soundness of markots and market pa/lldpanls."
H R- Rep No 97«. I02d Cong , 2d Ses*. 78.
However, the Conference Report on the 1992 Ad
also stales that:
"TtM Conferees do not Intend for this provisioa
to allow an exchange or any other existing DUrkel
lo oppose the exemption of a new produd solely
on grounds that it may compete with or draw
market share away from the existing market" — H.IL
Rep. No. 170. 102dCoog.. 3d Sees. 70(1092).
'The submission represents that each of the
memtien of the Elner^ Group is an adlve
participant In the prindpal domestic aod
international markets for crude oil and/or iiatural
gas and the produds and by-products thereof,
which regularly engages lo the purchase of such
commodities for use in Its business operations, the
sale of such commodities for use by end-users aztd
the transport of such cocnmodilles through pipelioe,
vessel or tnick detlveriea.
* Specifically, as staled In the apptlcaiion. see SS
FR at 0251. the exempUoa would:
"' * * preclude participation * • * by memben
of the gerveral public and * ' * Umll lb« * • '
{relief} to those appropriate persons who. In the
context of their business edivitlea. incur risks
related to the underlying physical commodities, to
addition, ^e exemptloo %inll require thai e*ch
* * * Contrad (covered by the relief would)
Impose binding delivery oollgallons on the panies
(with the exception of those covered liy * * ' [a
speciHed] proviso * ' *) and that it not provide
Conli»u9d
58
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Fadenil Register / Vol. 58. Na 74 / Tuesday. April 20, 1993 / NoUcw
The appIicanU further reuoned that
the exemption wai needed to provide
legal clanly and certainty reg£^ding the
trading of theae product*. In this regard,
at noted In the Federal Re^er notice.
58 FR at 62S1. the applicants contended
that the requested exemption should
"recognized the ability of commercial
entities to settle • • * Contracts
through the full ran^ of commercially
■vailanle forms of settlement," and
should "allow commercial entities to
conduct their necessary business
activities in the domestk: and foreign oil
and gas eoarkets * * * with the
requisite degree of legal certainty and
comfort"
In addition, the application also
addresaed the public interest to be
served by the Commiseion's issuance of
an order granting this request for an
sxempllon. The Comnussioa Included
this analysis in the Notice for comment,
quoting extensively from it. See, 58 FR
01 6251. In this regard, as noted in the
Federal Register notice, the applicant
reasoned that the exemption would be
in the public interest because "Itlhose
entities which satisfy * * * the
proposed exemption are sufficiently
sophisticated and knowledgeable to
protect their own interest in connection
with • • • Contracts, regardless of
whether the regulatory protections
afforded under the Act are available
* * '/'because "the exemptive relief
* * * is necessary in order to permit
commercial commodity markets to
function effectively * * *;" because
"the financial integrity of the markets
for such* * * Contracts will be
adequately addressed by the limitation
of appropriate persons and the measures
adopted by each market participant
atfhar party wfA Ihe unnatoral right to reqiilre itj
counterparty lo ofTs«t the contract by caih
Mttlement The Contracts witl therefore expose the
pertiea to eubetanttal ecooomk risk of ■ coimnercia)
Battire. Further, the Contnicti will be entered into
lietweeB two parties each of whtcb acts as principal,
and the material economic terms, including credit
terms of the tMHsactioo will ha subject to
individual negotiation betweeo the partiea."
The sppBcation further explained that the
requested ax eai pHo p:
"* ' * focnses on (ha comnercia] nature of the
parties and the {act that the * * * ContrBcts impose
binding delivery obligatlofU, thereby establishing a
*Vight line" test The exemption recognizes that-
regardless of the purposes for which the parlies
enter Into a* • • Contract, they may be required
by their counterparty to make or receive delivery
pursuant ID the terms of (he ContraoL This will
permit commercial entities to enter into ' • •
Contracts lor hedgjag, risk ukanagement, pridog or
other conM * e i c i al purpose*, ptorided that (he (emu
of the sgivemeets hspose biading delivery
obligatiooi. the parties are legally pemilned to
make ai>d receive delivBry ar>d ere capable of doing
se In this reeped as wril.theexflnplion win
fadliutetheiueof ■ * * CoatracU fer legitimate
and necessary basli>ess purposes." (CMetions
omitted.)
* * *;" and because "such Contracts
lack the degree of standardization and
fungibility required In order to permit
them to be traded on an exchange." Id.
Finally, the Commission included
seven issues on which It particularly
sought public comment. These included
the list of eligible "appropriate
persons," the CUimmission's description
of the commodities covered by the
exemption, its description of the cash
market, including the use of brokers and
of netting arrangements, the possible
effect on cxmtract markets from granting
the exemption, and whether section 4b
of the Act should be applicable to these
transactions.
C. Comments Heceived
The comment period closed on
February 26, 1993. Sixteen comments
were received; including eight from
active participants in the energy <ash or
forward markets or entities representing
such participtmts, three from futures
exchanges, three from futures industry
associations, one from a bar association
committee and one from an attorney. All
but one of the commeaters generally
supported issuance by the Commission
of the proposed order.
Most commenters confirmed the
accuracy of the Commission's
description of applicable of applicable
cash market practices. Several, however,
suggested changes to the Commission's
description, including in particular,
clarifications with regard to the degree
of standardization, or individual
negotiation, of these contracts. Several
further recommended that the
Commission clarify additional aspects
of the proposed order, including in
particular, the applicability of the order
to various other types of instruments
and other of the Commission's rules and
Interpretations.
Others recommended that the
commission modify certain aspects of
the proposed order. ITiese
recommendations included modifying
the persons proposed to be eligible for
this relief, the breadth of commodities
covered under the proposed order, and
the effective date oT the exemption. The
opposing commenler, the Chicago Board
of Trade ("CBT"), questioned the
Commission's statutory authority for
Issuing the order as proposed, the
rationality and fairness of the proposed
order and whether the Commission has
provided a meaningful opportunity for
comment on the statutorllyrequired
determinations regarding the public
interest which it roust make in issuing
this order.
n. The Final Order
Based upon Its careful consideration
of the application for exemption, the
comments received, and Its independent
analysis, the Commission is issuing an
order under its authority In section iid
of the Act to exempt specified
transactions from Commission
regulation. The final order, and in
particular, the modifications made to it
hora the proposal, are discussed below.
A. Statutory and Beguhtory Basis of the
Order
In proposing to issue this order under
sedion 4(c) of the Act, the Commission
made clear that It did "not intend to
determine whether Energy Contracts are
subject to the Act," nor to "affect the
applicability to Energy Contracts of
exemptions or interpretations
previously Issued by the Commission or
its staff, including the Stalutoiy
Interpretation Concerning Forward
Transactions. * ' * or the forward
contract exclusion set forth in section
2(a)(1) of the Act * * V" 58FRat 6253.
n.l8. The C3T, the sole commenter
opposing Issuance of the proposed
order, maintained that Issuance of this
order, pursuant to section 4(c) of the
Act. was inconsistent with prior actions
of the Commission and with the CBTs
reading of the scope of the Act's section
4(c) exemplive authority.
■The Congress, however, did not
Intend such a restrictive reading of the
Commission's 4(c) exemplive authority.
On the contrary, the Conferees stated
that:
"lo granting exemplive authority to the
Commission under new section 4(c). the
Conferees recognize (he need to create legal
certainty for a numlier of existing categories
of Instruments whicli trade today outside of
the forum of a designated conlrBCt market.
"The provision included in the (inference
substitute Is designed to give the Clommission
broad flexibility in addressing these products
"In this respect, the Conferees expect and
strongly encourage the Commission lo use Its
new exemplive power promptly upon
enactment of this legislation In four areaa
where significaot concerns of le^
uncertainty have arisen: (1) hybrids. (2)
swaps, (3) forwards, and (4) bank deposits
and acxounts."
H R. Rep. No. 978, 102d Cong. 2d Sets.
(1992|al«0-ai.
The conferees further stated that they
did
"not intend thai the exercise of exemplive
authority by the Commission would require
any delenuinatlon before hand that the
agreement. Instrument, or tra n saction for
which en exemptioa It sought it tubject to
the Act Rather. Ihii provitlon ptovldat
flexibility for the Commission to provide
legal certainty (o novel instnimenlt wh«t«
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Federal Register / Vol. 58. No. 74 / Tuesday, April 20. 1993 J Notices
21289
the d«termiDatioD «5 to Jurisdiction Is not
•trslghlforwimJ. Rather than making a finding
•< to whether ■ product 1» or Is not a futures
contract, the Ck)minlsslon In appropriate
cwet may proceed directly to Issuing an
exemption."
H.R. Rep. No. 978, 102d Cong, 2d Sess.,
(1992) at 82-83.'
Separately, several commenters
recommended modifications to the
proposed order on the grounds that
relief under the order was not as far-
reaching as the relief recently granted by
the Commission with regard to hybrid
instruments or to swap agreements.
Thus, one commenter argued that the
Commission should make this
exemption applicable to any cash-
settled energy contract because such
transactions arguably would be exempt
from regulation under the Commission's
Exemption for Certain Swap
Agreements. See. 58 FR 5587 (January
22, 1993). A second commenler
suggested that the Commission reiterate
that this relief was not intended to
vitiate the continued vitality of the
Commission's Statutory Interpretation
Concerning Forward Contracts, 55 FR
39188 (Sept. 25, 1990). Finally, a third
commenter requested that the
Commission clarify that this exemplive
order was not intended to supersede any
other Commission rule or interpretation
regarding those transactions which have
been characterized as forward or trade
option transactions.
In proposing this order, the
Commission made clear that It did not
intend to supersede or vitiate any other
of its rules or interpretations, in
particular those relating to the section
2(a)(1) exclusion of the Act. 58 FR 6253,
n. 18. Rather, this order was proposed
in response to a particular application
for relief, and was intended to provide
legal clarity with regard to certain
transactions as described therein in
specified commodities. Thus, the
Commission is limiting the order to
existing practices in these markets, as
represented in the application. Nor does
the Commission believe that the order
'In any event, the commenter maJDIains that
■■CEA i 4(c) compel! the CFTC, at the least, to
detenntne that every Instruoienl it exemplj could
be a futures contract." In this regard, the
CocnmUsion [wtes thai the le^ uncertainty which
thlj axeniptlve order addresses was occasioned by
the tMlief ol some observers thai some of the
Inj^umants at issue are Indeed futures cootrects.
See. e-g., Ti%insnor (Bcnnuda} v. BP North America
Pttrvltum. 7J» F Supp 1472 (S D N.Y. 1990).
Thiis, regardless of the Commission's position on
the appropriate charactertzatloo for specific types of
transections, the status of some of these transactions
under the Act appears likely lo be subject to
continued dispute, and this potential for
uncertainly provides a suffldenl basis for the
exatdae of exemptlve authority as lo these
transACtlona.
should go beyond the representations in
the application with regard to practices
in these markets to practices whic^ may
be permillod luider other Commission
rules, such as the exemption for swaps
in pari 35 of its rules. Finally, by
confining its order to these transactions,
the Commission is not thereby making
a determination regarding, or otherwise
determining the legality or status of, any
other type of transaction or superseding
any other rule or interpretation.*
B Commodities Eligible for the
Exemption
Several commenters suggested that
the Commission not limit this order for
exemption to Energy Contracts, but
rather extend it to all commtjdities. One
commenter suggested that an exemption
limited to energy contracts increases
uncertainty regarding forward contract
markets in other commodities, thus
requiring that the Commission expand
this exemption to cover transactions in
all commodities. A second commenter
argued that there was no legal basis to
distinguish energy products from other
commodities.
As discussed above, however, the
Cximmission, in proposing this
exemptive order, was responding to a
particular application for relief The
record before the Commission, and the
representations in the application, are
limited lo trading practices in the
markets relating to energy products. See.
58 FR 6251 , n 8. Moreover, the Congress
specifically directed the Cximmission to
consider the appropriateness of
exemplive relief for the crude oil
market. H.R. Rep. No. 978, 102d Cong.,
2d Sess. at 81-82 (1992).
Based upon the intent of the Congress
in enacting this exemplive authority,
and upon the limited focus of the
application for exemption and the
corresponding record, the Commission
is of the view that this final order is
appropriately limited to transactions in
Energy Contracts. Of course, as the
Commission noted previously, this
exemption in general, and its limitation
to Energy Contracts in particular, does
not affect the applicability or vitality of
existing Commission policies or
interpretations regarding transactions in
these, or any other, commodities.
Several commenters also requested
that the Commission make technical
amendments to its enumeration of
• In this regard, the Commission reiteraros that the
exemption granled here does not alTact the
applicability lo Eoer^ Contracts of the
Commission's Statutory Interpretation Concerning
Forward Transactions. 55 FR 3918* (Seplember 25,
1990). Any transaction that has been or will be
wlered Into coiuislent with that Interpretation
remains excluded from regulalion under die Act.
commodities included within the
meaning of the term "Energy Contract."
The Commission defined this term In Its
Notice Proposing Issuance of an Order
as. "contracts for the purchase and sale
of crude oil. natural gas. natural gas
liquids or other energy products,
Including products derived from crude
oil. naluralgas or natural gas liquids,
and used primarily as an energy source
• • •."58FR6251.
In particular, one commenter
recommended that "condensates"
should be explicitly included within the
commodities enumerated. The
Commission agrees. Other comments
reflected confusion over whether a
product must actually be used as an
energy source in order to be included
within the exemption. The Commission
did not Intend that inclusion of a
particular product within the exemption
rest upon a sub)ective test of Intent as
to its use as an energy source. For
example, a particular company may
purchase cargoes of crude oil for use in
various commercial activities. The
Commission did not mean to exempt
only transactions for those specific
shipments of the specified products
which are used as an energy source.
Rather, the enumerated products — crude
oil, condensates, natural gas and natural
gas liquids, which can be used In their
natural stale for energy— are included
within the exemption regardless of
whether the actual or ultimate use of
these commodities is as an energy
sourc».
Derivatives of these products are
included to the extent that the
derivative product is used primarily as
an energy source. Again, however, it is
the derivative product itself, such as
gasoline, heating oil, or diesel fuel, and
not the use made of particular lots of a
fungible product, which is included
under the exemption. The Commission,
therefore, in its final order, la clarifying
the description of the commodities
included in the exemption.
C. Entities Eligible for the Exemption
The Commission, in its Notice,
specifically requested comment
regarding its enumeration of the entities
which would ]>e eligible for exemptive
relief. This request elicited diverse
opinions which raised several Issues. As
proposed, the exemptive order would
have been applicable to "commercial
participants who. in connection with
their business activities, incur risks
related to the underlying physical
commodities, have the capacity to make
or lake delivery under the terms of ihe
contracts, and are also eligible
'appropriate persons.' " The
60
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Federal Register / Vol 58. Ng 74 / Tuesday. April 20. 1993 / Notices
CommUstoD birther deOoed "eligible
eppropriate persons" u:
"(1) A tiuik or tnut cxxnpluy (acting Id an
Individual or fiduciaiy capacity) which U
le^lly penBitted and otherwise authorizad to
engage In such traiuactiona; (2) a
corporatioo, partDanMp, proprietorship,
organization, trust, or other business entity
with a net worth exceeding $1,000,000 or
total assets exceeding {5,000,000, or the
obligations of which under the agreement,
contract or transaction are guaranteed or
otherwise inpparted by a letter of credit or
keepwell aupport, or other agreement by any
sucn entity or by an entity reierTsd to in
subsections (H), (I) or (J) of Section •«(c)(3);
(3) any govommenta! entity (including the
United States, any state, or any foreign
government! or political subdivision thereof,
or any rauhir>ational or supranational entity
or any insuumentaiity, agency, or
departmeol of any of the foregoing; (4) a
broker-dealer subject to regulation under the
Securitiea Exchange Act of 1934 (1 S US.C.
78a et seq.) acting on its own behalf or oa
behalf of another appropriate person (as set
forth herein); and (5) a futures commission
merchant subject to regulation under the Act
acting on Its own behalf or on behalf of
another appropriate peraon (as set forth
herein).'*
58 FR 6257.
Several commentars opined that the
entities eligible Tor this relief should be
extended to include not only
"commercial participants • • • who
incur risVs related to the underlying
physical commodities, land] have the
capacity to male or take delivery
* • *," but also to include any
appropriate person which is legally
authorizad to make or take delivery of
the physical commodity. These
commentert further suggested that an
entity could so qualify "by contracting
out its obligations to a person or entity
that provides such services as storage or
transportation of the underlying
commodity,**
In addition to the above revision to
eligibility, several commenters also
supported the inclusion oF commodity
pools within the list of "eligible
appropriate person," These commenters
supported this revision by reasoning
that, "because there is no basis to
distinguish between them (commodity
pools) for purposes of exemptive relief
under section 4(c)," commodity pools
should be included within the terms of
thii exemption "on the same terms as
swap transactions.**
Other commenters disagreed with Oiis
view. One such commenter, a futures
exchange, contended that permitting
commodity pools to be covered by the
exemption was contrary to the proposed
order's stated rationale, reasoning that;
"Itlhe purpose of the IVt^nsed OnleT Is
ostensibly to permit tiansarllrws which are
entered Into Cor legUtmale oomB>eTcial
purposes * * *. To treat a speculative
commodity pool * * * as the equivalent of
an entity engaged In the business of being a
producer, processor and/or merchandiser of
energy products, is contavy to the Proposed
Order's ol^ectlve of facilitating commercial
activities free of unnecessary regulatory
burdens * • *."
Based upon the above reasoning
amphasinng the commercial nature of
the eligible entities, the commenter
further recommended that the
Ckimmission state explicitly that eligible
parties under the exemption must have,
"as part of the routine course of their
business activities. • • • the physical
capacity to produce, refine, store,
transport or otherwise tangibly control
the commodity." and questioned the
need for conditions related to net worth
and total assets. The commenter noted
that by limiting the exemption to
commercials, it would apply only to
sophisticated entities and that the net
worth and total asset conditions were
therefore unnecessary, potentially
excluding unnecessarily "small or start-
up commercial entities * * *."
After carefully considering the views
of the commenters, the tx)mmission is
limiting the final order to those types of
commercial participants identified in
the proposeo order. The Commission is
persuaded that this is appropriate in
light of the limited nature of the
application, and In li^ of its
understanding of the nature of the
transactions and the participant**
currently in these markets.
Consistent with this determination,
the Commission is tnaking clear that
this exemption remains applicable to
transactions that result in risks relating
to making or taking delivery of the
underlying physical commodities.
Accordingly, the category of eligible
appropriate persons for this exemption
must have a demonstrable capacity or
ability to make or take delivery. As the
Commission explained in the Notice
Proposing Issuance of an Order, at page
6252. "such capacity entails the ability
to produce, refine, store, transport or
otherwise tangibly control the physical
commodity." This can be fulfilled,
however, by bona fide contractual
arrangements for these services.
Moreover, despite some merit in the
observation that certain smaller, or start-
up commercial firms may be excluded
unnecessarily from eligibility for this
exemption by the net worth and total
assets conditions set (orth in section
(A)(ii) of the Order. Ui light of the
general nature of the current
participants in the markets, the
Commission believes that smaller
commercial fimu, which cannot meet
these financial criteria, should not be
included. In this legard, size Is a
relevant proxy for measuring the
expertise of, and participation In these
types of markets, and for an enlHy*!
capability of making or taking delivery
in these markets. Moreover, the
Commission notes that even smaller or
start up firms should be able to meet
these financial requirements through the
use of various types of permitted
guarantees, and thereby qualify for this
exemption.*
On a separate issue, one commenter
requested that the final order also
exempt "any person or class of persons
offering, entering into, rendering advice,
or rendering other services with respect
to such Energy Contracts, in connection
with such activity," The commenter
reasoned that extension of relief to those
advising or rendering advice or other
such services in connection with these
transactions, which was included in the
exemption for swap and hybrid
instruments, is equally applicable to
this proposed exemption.
Consistent with sectrtm 1(c)(1) of the
Act end the Commission's exemptions
for swap and hybrid instruments, the
Commission is providing that persons
offering, entering into, rendering advice,
or rendering other services with respect
to such Energy Contracts are eligible for
this exemption.'®
*ln Ihif regard, although ttie Commission has nol
provided that ouDisodtly pools or oOwc coHectiva
invmbrenl vehidM. including rnTestmeiil
cooipafues. or Ooor brokan and floor tjadflrs
separately coostilule daises of "appropriate
persons." to the extent that such enbties qualify for
exemplioji as an eligible aality under another
category of "appropriate persoa." they will oot tie
excluded from the exemption. Accordingly, such
entities may qualify as appropriate persoru If. In
connection with their tntstness aclivitiea. they tnciir
riski. In addj tion to price risk, related to tl>e
imdertyiBg physical conunoditie&, have a
demonstrable capadty or ability, directly or IhrtHigh
separate bono fide contractual arraDgements. to
make or take tielivery ondei the terms of the
contracts, are not prxsKibited by law er regulation
from entering into such contracts, and otherwise
meet the qualtlrcatioos set (orth in one of the
enumerated categories of appropriate persons.
However, any collective investment vehide formed
solely for the purpose of entering into Energy
Contrects will iu>t tjuelify for the exemp<iv« relief
provided under the Commission's Onler. Of oourse.
a (xmiDodity pool operator will cmtiiuie to be
subject to Section 4o of the Ad in ccuurection with
iu solicitatiofu or other adivibas es a CPO evan
though it may purchase or direct the patzhate ot
Energy Contracts that are suhfed to the
Commijaion's Order.
x> As the CommtsskM ootad in the Notice
Proposing Usuaisca at an Ordec it did "not tBland
that the proposed coiutiUosi that an Eisergy Cootiect
be a priridpal-to-priaclpftl tr«B*actM0 preclude the
tsj* of brokWi Of other agents in cennectieii with
the negotiation oC ar the perfonnanoe or aetlleoMist
of the obligariOBS ur>der. a contrect * * "- $• Fit
6232, n.t1 The fijul onlar m^m dear that M
eocom passes agenu readarlag sedh mrwUjm.
including advisory services, for those aotivitiea.
61
Federal Register / Vol. 58. No. 74 / Tuesday, April 20. 1993 / Noticas
21291
However. M explained lo connection
with the exemption (or swap
trajMaction*. the application of tbii
exemption to such persons
"engagod Id activity otherwlM sub^xrt to the
Act would DcM fa« oxempt Cor fvxJl activity,
even If II ware cooiMctod to tiwlr
exempted • • • (Enelgy Conlracil activity.
Also in this regard, the Commiuion wi&hes
to malie dear that the exemption d< >&» ool
appTy to any financial, recordkeeping,
reporting or o<heT requirements Imposed on
any pereon in coaD«ction with their activities
that reniala subject to regulation under the
Act. Thus, for axampla, hitures commijaion
merchants omst oootioua to account for any
liabilities arising out ot any * * •(Energy)
agreement Ln meeting ihe net capital
requirements ofCommisslon Rule 1 17 just as
they do in the case of other financial
instruments not regulated under the Act.
Similarly, tbe risk assessment recordkeeping
and reportfrtg requirements imposed on
futures commission merchants by Dew
section 4flc) of the Act apply ' • •."
58 FR at 5580.
Finally, several commenlers suggested
that (he Commiasion clarify the rote of
written representations in forming a
reasonable basis for the belief tliat a
counterparty qualiSes as eligiblu for this
exeoiplion. A second cotnmenler
requested that the Commission also
clarify that a reasonable belief is
required as to the counterparty's
eligibility with respect to Doth its
capacity for delivery and its inclusion as
an eligiole appropriate person.
These determinations, that there is a
reasonable basis to believe that a
counterparty is eligible to enter into the
transaction both with regard to its
capacity and as an appropriate person,
are lo be made at the inception of the
transaction. Moreover, an eligible entity
that has a reasonable basis to believe its
counterparty is also an eligible entity
when entering into a master agreement
may rely on such representations
continuing, absent information lo tbe
contrary." Compare, 58 FR at 5589.
D. Description of Exempt Transactions
In general, commenters agreed with
the accuracy of the Commission's
description of the operation of these
markets In energy products. However,
the entitle* which Tiled the application
for this exemption, sought, in their
comment tetter, to distinguish the
relativs degree of individual negotiation
over particular categories of the
contract'i economic terms. In particular,
this commenter pointed out that the
terms of the transactions regarding
quality and location lo many of thesa
markets, because they Involve "a single
supply location," "are Gxed and not tbe
subject of individual negotiation."
The Commission U aware that the
terms regarding tbe quality and location
of Energy Contracts, as well as other
conventions surrounding their trading
are standardized- Novertbeless, these
transactions can be distinguished by the
fact that, because their credit terms ar^
Individual to the counterparties, they
are not fungible and are created through
the direct negotiation of the parties lo
the transaction. Compare, S8 FR at 5591.
Several commenters also requested
that the Commission confirm that the
requirement for binding delivery on the
contracts is not affected by inclusion in
the contract of a termination right which
is triggered by an event of default, such
as the insolvency of a counterparty. The
Commission concurs that bona fide
terminations occurring under the terms
of a contract, for contingencies such as
default or insolveitcy that are not
expected by the parties at the time tbe
contract is entered into, will not
invalidate application of the exemption
to the transaction, bi this regard,
however, the Commission cautions that
the inclusion of such provisions, end
their use, must be bono fide and not for
the purpose of evading the terms of this
exemption.
Finally, one commonter argued that
the proposed order is arbitrary because
it would have exempted only contracts
which were bilateral and not subject lo
a mutual risk clearing system." The
CBT concluded that this is contrary to
the public interest because those
methods which are included wilhin the
exemptive relief are, in its view, inferior
lo a true clearing system, which is not
included within the scope of this order.
As the Commission has noted elsewhere
in this release, however, this order is
responsive to the appHcation for relief
and is tailored to current practices in
these markets. Accordingly, the order is
limited in scope to bilateral,
individually negotiated instruments,
which is the common practice in these
markets.
"As under the Put 33 rules, where a
counterpwly has ceased to be eGgible for this
exemp4ioQ. an eligible eoUty aevertheleu may eiUar
Into a "dosing Uansactloo" with Iha counts/party
to tenninele aJI obllgaboaj berwean them. See. Sa
FRatssas. n. ia
"As the Commission noted in the Notice
Proposing an Order
"The reqiiirefneal that Energy Contracts be
bilateral and sub)ect lo individual negotiatloa la
Intended to assure that the IrHnsaclioru >v ould not
be subjocl lo a clearing system where the aedil risJi
of individual panicipants of the system lo each
other, with respect to a transaction to which each
is a counterparty, would eftedively be eliminated
and replaced by a * ' * system of muluJixed risk
of toss that binds members generally whether or ool
they are counterparties to the original
transect ion.'— 58 fH at 6J53. il 1 1.
B. Breadth of Exemplht Relief
Tbe Commission requested coaiment
on whether it should reserve aotl-fraud
jurisdiction under section 4b of the Ad,
7 U.S C 6b. over these instruments. No
commenler explicitly supported the
retention by the Commission of anti-
fraud jurisdiction. To the contrary,
almost all of the commenters opposed
reservation of this authority. Most
agreed with the views expressed by one
commenter that:
"ICtiven the commercial characteristics ol
those transadiona and the significaat
requirements to he 'commercial participants'
and 'appropriate persons.' the (commentar)
* * * does not believe that soclion 4(b) (ale)
of the Ad (anti-fraudi should t>e applied to
Energy (xm tracts,"
In this particular instance, the
Commission concurs with the
commenters that it need not retain
section 4b authority, lo whatever extent
that section of the Act would otherwise
be applicable to these transactions."
However, sections 2(aUl)(B) of the Act
end the provisions of sections 6(c), Gc.
6(d) and 9(a)(2) of the Act. to the extent
that these provisions prohibit
manipulation of the market price of any
commodity in interstate commerce or
for future delivery on or subject lo the
rules of any contract market, will
continue to apply.**
Finally, several commenlers requested
that the Commission broaden the
exemption by making its application
retroactive. As proposed, the
Commission's order would have been
effective upon publication for all
executory transactions. Various
commenters objected. One reasoned
that:
■■|l|t the CTTC determines that issuing the
proposed exemption is consistent with tbe
public interest, its determination should
eliminate any legal uncertainties with respect
to Energy (Contracts entered into before as
well as after the effective date of the
exemption. The CFTC's final rules exempting
"Of course, that is not to say tiiat the
Commission's decision ool lo reserve Sactlob 4b
anIl-fratKl jurisdiction will leave market
paxticipanis without legal recourse for fraud Id
connection with these l/ansacUoni. Market
parlicipanis will continue to b«ve available those
slate and comaioa tew remedies whlctk have bean
applicable to these markets from Iheir loceplloA.
<* Moreover, as the Commlssloo noted lo Its
Notice f^posing Usuaisce of an Order, al Sa FK
e2S3. n.19. this order "would not aflsd lb*
appllcebillty or proiectioos of stale law (other IfaaD
gaming or "bucket shop" lawsj. or aiUifnud statutaa
of general appUcabtllly. to the exempted Qsaqor
(Contracts or any other prolectlons provided try
other applicable tedetaj laws. Congress sped/loally
Ikoted that, la axampHog an Instrument bom the
Ad. the Commlssioa caoaot exempt It froa
applicable sacurlUee and bairiUng Laws and
regulations " H-R. Rap. No. «7a, UM Coof.. Id
SessBl (19921.
72-584 0-93-3
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certain iwap and hybrid tranaactlont apply
retroactively, and • • • |iho commenlorl
seea no reason why the proposed exemption
should not alio apply to existing Energy
Contracts."
In light of the Commission's objective
in issuing this order — to provide greater
legal certainty regarding the trading of
these instruments — ana the uniform
opinion of the commenters that the
retroactivity of the order is an important
component of providing that certainty,
the Commission has determined that
upon the order's effective dale, it will
apply retroactively, to all such
Ironsaclions entered into on or alter
October 23, 1974. This is consistent
with the Commission's recent
promulgation of rules exempting certain
swap transactions, 58 FR 5587, and
certain hybrid instruments, 58 FR 5580
(January 22, 1993).
F. Public Interest and Purposes of the
Act Determinations
1. Publiclnlerest
In determining that its actions are
consistent with "the public interest and
the purposes of its enabling statute, an
agency, such as the Commission,
applies the standard against the
template of its overall regulatory
scheme. In this regard, the Conference
report stales that the "public interest"
under section 4(c) includes the
"national public interests noled in the
jAcll, the prevention of fraud and the
preservation of the financial integrity of
the markets, as well as the promotion of
responsible economic or Rnancial
innovation and fair competition." H R.
Rep. No. 978, 102d Cong., 2d Sess. 78
(1992). '• The Conference Report goes on
to slate that "lljhe Conferees intend for
this reference to the 'purposes of the
Act' to underscore their expectation that
the Commission will assess the impact
of a proposed exemption on the
maintenance of the integrity and
soundness of the markets and market
participants." Id.
Energy Contracts are used by certain
commercial entities that are engaged in
the production, refining, processing or
merchandising of crude oil,
condensates, natural gas, natural gas
liquids, or their derivatives which are
*'OiHi commenter. a fururea exchange. In Its letter
notes tlut Id addrBSslng certain elemenli of the
public InterMt for futures trading. Congress has
indicated that contract mariet designation and
ragutaliDa under the Act is necassary to avoid
creating an undue tmrden on couunerce Sm
Section 3 of tlie Act. Seventy years after the
eoactment of Section 3. however. Congress enacted
Section 4(c] authorizing exemptions from Section
4(a) of the Ad, for certain products, because
"traditiooal futures regulation * ' • may create an
inappropriate burden on commerce." H.R. Rep. No.
97«. 102d Cong., 2d Sess 80 (1992)
used primarily as an energy source.
Energy Contracts are used by these
entitles and other commercial entities In
the conduct of their businesses.
Reportedly, these markets have been
chilled by the legal uncertainly
surrounding these transactions. The
Order should reduce uncertainty, thus
allowing participants to nsgoliale and
structure Energy Contracts In ways that
most effectively address their economic
needs, and thereby enhancing the global
competitive position of U.S. businesses.
As noted by one commenter,
"Congress, when considering passage of
the IFulures Trading Practices of 19921,
acknowledged that the mandatory exchange-
trading requirement, if applied to every
commodity transaction having the indicia of
a futures contract, may cause foreign market
participants to engage in such transactions
outside of the United States, creating
'competitive disadvantages for U.S.
participants.' "
2. Material Adverse Effect on Regulatory
or Self-Regulatory Responsibilities
In mailing this determination.
Congress indicated that the Commission
is lo consider such regulatory concerns
as "market surveillance, financial
integrity of participants prolection of
customers and trade practice
enforcement." '"
The record before the Commission
does not support a conclusion that the
purpose of the Ad or the Commission's
regulatory efforts thereunder have been
adversely affected by the use of Energy
C)ontracts or will be so by the issuance
of the order Energy Contracts have been
entered into by commercial participants
in the energy markets for a number of
years, without any apparent adverse
impact on market surveillance, financial
integrity of participants, protection of
customers and trade practice
enforcement of regulated markets.
Specifically, the Commission has
addressed concerns regarding financial
integrity and customer prolection
through the requirement that Energy
Contracts may only be entered into and/
or only be transacted on behalf of
"appropriate persons", as defined
above. This approach ensures that such
transactions involving Energy Contracts
will be limited to sophisticated entities
engaged in the businesses described
above and who are financially able to
bear risks associated with such
transactions."
The Commission also noted that (be
existence of Eneivy Contracts to data
has not affected the ability of futures
exchanges to fulfill their self-regulatory
duties." In this regard, commenters
have asserted that the futures market
and the Energy Contract markets are
linked, with many of ihe same
commercial entities using Energy
Contracts also using the energy futures
markets for hedging purposes. By
creating a more certain legal
environment for Energy Contracts, the
potential for systemic risk due to
disaffirmance of sutJi contracts as
invalid under the Act is reduced, and
there is no reason to conclude thai the
exchanges' self-regulatory
responsibilities will be adversely
affected by permitting transactions
under Energy Contracts to continue on
this basis."
3. Anticompetitive Considerations
Section 15 of the Act provides, in
relevant part, that the Ciimmission must
consider the public interest to be
protecled by the antitrust laws and
endeavor lo take the least
anticompetilive means of achieving the
objectives, policies, and purposes of the
Act in adopting any rule, regulation, or
exemption under section 4(c). '° Thus, a
formal analysis under the antitrust laws
is not, by ilself, dispositive of Ihe issues
raised by a Commission action."' As a
result, the Commission is not compelled
by section 15 lo lake the least
anticompetitive course of action. Rather,
where alternatives with varying degrees
of regulatory benefit exist, the
'"H.R. No 97«. 102dCong. 2d Sess. 79(1992)
"In enacting the 1992 Act. Congress explicitly
authorized exemptioru from alt provisions of the
Act (except section 2(aKlKB)) and simultaneously
enacted a " conforming amendment" to section
12(e|(2) explicitly acknowledging that State
antifraud statutes of general applicability would
continue lo apply lo exempted transactions.
'•In this respect, neither of the two futures
exchanges commenting on Ihe proposal indicated
that the proposed order will adversely afTect ibeir
self-regulatory responsibilities.
'"The Commission is uruwareof any Energy
Contracts that provide for settlement by leitiettn%
an exchange-created delivery instrument, such as
an exchange-approved depositary or depository
receipt or shipping certificates, ttiat is specified in
the r\iles of any designated contract market Energy
Contracts which did specify such delivery
Instruments could have an effect on certificated
supplies for settlement of designated futures or
option contracts and. accordingly, the rreabon of
Energy Cjantracls specifying such delivery
instnimenls should only occur after consuitatioQ
with IheCommissiorL
"* Specifically, section 15. as amended by section
S02(b) of the 1992 Act. provides:
"The O^mmissiOD stull take Into considaratioD
the public interest to be protected by the antitrust
laws and endeavor to lake the least anticompetitive
means of achieving the objectives of this Act. as
well as the policies and purposes of this Act. in
issuing any order or adopting any (!!otniiiissMO rule
or regulation (including any exemption under
sections 4(c) or 4c(b), or in requiring or approving
any bylaw, rule, or regulation of a contrad mariet
or registered Futures association estabiishwl
pursuant to section 17 of this Act."
» See Cordon v. New York Slock ExcAorife. 422
U S 659. 69(V-e9l {it7l); Silver y. NtwYaik Slack
Exchange. 37J U.S. 341 II963).
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21293
Commistion may adopl the approach
that appears to Nb Iha raott likely to
achieve the objective*. poUde*. and
purpose* of the Act. even if that
approach is not the least
aiilicompetitive.''
Accordingly, section IS reouires the
Oramissfon to balance the likely
anticompetitive impact of its action
against the objective, policy, or purpose
of the Act which that action may
further. And. although the Commission
must consider the public interest in
maintaining or promoting competition,
it need not weigh this interest equally
against an objective, policy or purpose
of the Act being served in reaching its
final determination.
The Commission's consideration of
the proposed order and its evaluation of
the comments received in this regard
has led it to conclude that any possible
anticompetitive effects are clearly
outweighed by the order's furtherance of
the policies, purposes and objectives of
the Act. First, the proposal does not
appear to raise any significant
competitive issues. As a number of
commenters noted, the exemption, by
improving the legal certainty o( Energy
0>ntracts. will reduce the risk that the
physicals market may be disrupted.
Commenters also noted that grajiling the
exemption could result in expanded
participation by foreign and domestic
energy companies. Accordingly, the
exemption furthers a fundamental
objective of section 4(c)(1) of the Act.
i e.. promoting "responsible economic
or financial innovation and fair
competition."
For the reasons explained above, the
Commission, based upon the
appropriate determinations made in
accordance with the standards set forth
In section 4(c) of the Ad. hereby issues
the following Order
Order of the Commodity Futarps
Trading Commiirion Exempting From
Regulation (Excapl as Specified)
Certain Eoar^ Cootxacts
Wherras, it is the Commission's
understanding, based upon
representations contained in an
Application (or Exemption, dated
November 16. 1992. that contrarts for
the purchase and sale of crude oil.
coadensale*. natural gas, natural gas
liquids, or their derivatives which are
u^d primarily as an energy source, by
their terms. Impose binding delivery
obligations on the parties ("Energy
Contract*"). These &iergy Contracts do
nol provide aUbsr party with the
unilateral right to offset the contract or
to discbarge its obligatioo under the
contract by a cash payment, except
pursuant to a bona fide term of the
contract permitting the unilateral
termination of the contract for force
majeure, insolvency or bankruptcy of
one of the parties, default or other
inability to perform, unexpected at the
time the contract is entered Into ("bono
fide termination right"). Energy
Ointracts thus expose the counterparties
to the substantial economic risk of a
commercial cash market transaction in
which delivery of the product is
required pursuant to the terms of the
contract. Furtlier, Energy Contracts are
entered into between principals, and
their material economic terms
(including, in particular credit terms)
are subject to individual negotiation
between the parties.''
The Commission further understands
that parties to Energy Contracts satisfy
or otherwise settle their obligations
through several types of commercially
acceptable arrangements, including the
seller's passage of title and the
purchaser's payment and acceptance of
the commodity underlying the
contract." Passage of title and
acceptance of the commodity
constitutes performance under a bona
pde contract regardless of whether the
buyer lifts or otherwise takes delivery of
the cargo or receives pipeline delivery,
or as part of a subsequent separate
contract, passes title to another
intermediate purchaser in a "chain",
"siring " or "drcle" within a "chain."
The physical delivery obligation
spedfied in an Energy Conlrad entered
into between two [)art)es can also be
satisfied through various other
arrangements between the parties. For
example, in the case of crude oil and
crude oil produds, the physical delivery
obligation could be satisfied by
exchanging one quality, grade or
produd type for another quality, grade
or produd type. Such transadions are
referred to in the industry as "grade
and/or quality swaps" or "exchangea."
In addition, the obligation could be
satisfied by location swaps.
In addition, two parties to an Energy
O^nlrsd may enter into a bilateral
"netting" or other similar agreement.
subsequent to the exscutiiiD of m
Energy Ointract." Under (uch an
agreement, the two partiw agree to
"net" or "book out" the obligstioa*
imposed under two or more Energy
Contracts which provide for delivery of
the same commodity at the same
delivery location and during the same
delivery period and thus cancel each
other. Such a netting agreement can be
entered into at the time that the
canceling Energy Cxintrad is originated,
or subsequently, through a different
agreement, at a time prior to when
performance on the contracts otherwise
would bo due."
The Commission further understand*
that under current market practice, the
parties to the original contrsd may enter
into a subsequent agreement ( "second
conlrad ") which provides for settlement
in a manner other than by physical
delivery. The second contrad, however,
cannot stand alone as an independent
transaction: it is inddenlal to a pi9-
existing, bona fide Energy Contract.
Moreover, the establishment of the
second conlrad caruiot be made a pre-
condition of the initial Energy Contrad:
e g , one party cannot require its
counterparty to agree in advance to the
establishment of the secoiui contrad as
a condition of acceptance of the Initial
Energy Contract Accordingly, the
second contrad is a separately
negotiated agreement and, if the
counterparty subsequently does not
agree to the second contrad, the parties
remain obligated in accordance with the
binding delivery requirements imposed
under the initial Energy Ck)ntract.
Existing market practice also permits
three or more parties, upon Tmding that
they form a "chain", or a "string " or
"drcle" within a "chain", to satisfy
their obligations under an Energy
Contract, whether or not title passes or
"Sea. Ag.. BrSish Anwrkan Commcxlity Options
C-jrp » Bofiley, Comm. Pol L F«p (CCH). »J<S
•I 2I3MISD.N.Y. l«7e,). tffd In faxlajiditx'd in
port. Ml ?.li *»1 (Id Or. 1977). cat denicrf. 4M
US 93* (1977).
'' Paxtias to Dloiq^ CoJitracIs mtj eslabtisli
biUloral coJIaleral or other credit protect:ua
arrangenientf. nich a5a letter of credit or uttier
documaotarion of fuod) avaiUbility. (o aiMress
aedil IsaoAS.
'*Cash mafiel fraosadiona In crude oil,
petroleuin producu. oabtra] gas aitd nati:ral gaa
liquids, as welt as othar energy related commodHiea
In which pky^cai deTivery is made, are pfTeded
Ihrou^'h payinenl Irv the truys and transfer of Ulle
try the seller to the Duyar.
" In the energy maiketa, tlie terms "book out"
(crude oil) and "book Irajufsr" (other petrvlewB
pioducis) are cash aiarkel tensj that geoefafly lefar
to ttie CAOceltabon or nettiog oApfaysicat delirery
obligations lietween parties, the primary purpose ot
which is to prevent ot fninlmize the urvecnoomjc
movetseni of the pkyaica} cotRiDodity.
""Rather than agreetog to Dst partioslar cancettng
Ener^ Contracts, two frequent counterpanLas. for
purposes of ease of admisistxalioe.may usaa
"master."* or other form of bilaterat a^reameot to
achieve the sanae result. This inas>er agreement,
eslablistled prior to entry tnio tbe ta^rgj Coolracls.
pitjvides that lb« two coualerpartres a^na to oM
ener^' Contracts of the same coomuxlily at lh«
same location and during the same delivery period.
This agreement replaces the practice thai
counterparties agree to net partkular cBBcebng
Energy Cgnlncis. eitUer to rtia tuna the sacoiia
coaliacl is entered Into, oe by a sapenla.
tubsequast agreeoieol. with the onderstaAdlag Ibat
all camrttcls between Umb wbrcb caocaJ earii otll«
wilt b* netted, tmlaea tbay bave agreed not to appJy
the prior netting agreamaot at Iba lime of entry into
an Energy Contract.
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Federal Re^ster / Vol. 58, No. 74 / Tuesday, April 20, 1993 / Notices
ii deemed to pan, through ■
subsequent, separate agreement, with
unanimous consent of the parties, to
"book out" and satisfy their obligations
through separately negotiated bilateral
cash payments or other mutually
acceptable terms. It hat been
represented to the Commission that
such arrangements are common In the
energy cash market." They are standard
commercial practice to avoid and/or
minimize transaction costs, non-
economic payments and product
movements, and for reducing the
number of transactions necessary to
perform all obligations between parties
pursuant to the contracts which are
"booked out."
And whereas, this order is limited to
(A) commercial participants who, in
connection with their business
activities: (1) incur risks, in addition to
price risk, related to the underlying
physical commodities; (2) have a
demonstrable capacity or ability,
directly or through separate bona fide
contractual arrangements, to make or
take deUvery under the terms of the
contracts: (3) are not prohibited by law
or regulation from entering into such
Energy Contracts; (4) are not formed
solely for the specific purpose of
constituting an eligible entity pursuant
to this Order; and (S) qualify as one of
the following entities:
(i) A bank or trust company;
(11) A corporation, partnership,
proprletorsnip, organization, trust, or
other business entity with a net worth
exceeding SI. 000,000 or total assets
exceeding $5,000,000, or the obligations
of which under the agreement, contract
or transaction are guaranteed or
otherwise supported by a letter of credit
or keepwell support, or other agreement
by any such entity or by an entity
referred to in subsections (A), (B), (C),
(H), (I) or (J) of section 4(c)(3);
(lii) A broker-dealer subject to
regulation under the Securities
Exchange Act of »34 (15 U.S.C. 78a et
seq.);
(iv) A futures commission merchant
subject to regulation under the Act; or
(B) Any governmental entity
(including the United States, any state,
any municipality or any foreign
government; or political subdivision
thereof, or any multinational or
supranational entity or any
''TIm uMof farokfln. agantt or « Ihlrd-party lo
IdenUfjr 111* «xU(eoc« of • "duiD" or lo faciltlAI*
lb« l>ll4lonlly Mgotialed "book oul" oriTwuaclloiu
forming ■ "chain" It oot doemed lo conitilule •
clearing tystem. The Cocumluloo hu been advisod
thai tbm tn ■ number of third-parly broker* and
■geoU who provide thli lervice In ihe energy cash
mark«l.
instrumentality, agency, or department
of any of Ihe foregoing;
And whereas, this order also
encompasses persons offering, entering
into, rendering advice or rendering
other services with respect lo the
agreement, contract, or transaction
which is the subject of this Order, for
such activity;
The Commission, pursuant to section
4(c) of the Act. hereby exempts from all
provisions of the Commodity Exchange
Act, 7 U.S.C. 1 et seq., except sections
2(a)(1)(B) of the Act and the provisions
of sections 6(c), 6c, 6(d) and g(a)(2) of
the Act. to the extent that these
provisions prohibit manipulation of the
market price of any commodity in
interstate commerce or for future
delivery on or subject to the rules of any
contract market, the following
transactions, entered Into on or after
October 23, 1974:
Contracts for the purchase and sale of
crude oil, condensates, natural gas,
natural gas liquids or their derivatives
which are used primarily as an energy
source, and which:
(1) Are entered into by and between
participants covered by this Order, having at
initiation of the contract a reasonable basis to
believe that its counterparty Is also within
the terms of this Order.
(2) Are bilateral contracts between two
parties acting as principals, the material
economic terms of which are subject lo
individual negotiation by the parlies; and
(3) Impose binding obligations on the
parties to make and receive delivery of the
underlying commodity or commodities, with
no right of either party to effect a cash
settleraent of their obligations without the
consent of the other party (except pursuant
lo a bona fide termination right), provided,
however, that the parties may enter into a
subsequent book out. book transfer, or other
such contract which provides for setllemeDt
of tiie obligation in a marmer other than by
physical delivery of the commodity specined
in the contract
Issued in Washington, DC, this 13th day of
April. 1993, by the Cxjmmlssion (Acting
Chairman Albrecht and Commissioner Dial
concurring, Commissioner Balr dissenting).
)tto A. Webb.
Secretary of the Commission.
Concurring Opinion of Acting
Chairman WUliam f. Albrecht
Today we have before us an
exemption for large commercial
participants in off-exchange energy
based transactions. These transactions
compose a large ongoing maikel for
eneigy products of importance to U.S.
and international commerce. We are
considering this exemption in response
to a petition submitted by several
market participants who seek further
certainty that this market Is outside
CFTC regulatory jurisdiction.
This market for energy product* ha*
been in existence for many years and
over those years it has grown in size,
importance and complexity. The
Commission has never regulated this
market, nor has it sought to regulate It.
The market is characterized by principal
to principal transactions between large
sophisticated commercial entities. The
Commission is not aware of fraudulent
practices perpetrated against the general
public by the participants in this
market, nor Indeed have any of the
commercial participants in this market
complained to the Commission of
fraudulent practices by other
participants. Also, there generally do
not appear to be any concerns about the
ability of these market participants lo
perform their obligations. Absent two
events it is doubtful that the pelllloners
would have brought their request to us.
First, a vast number of transactions
previously not considered to be within
the scope of the Commodity Exchange
Act were brought into question by a
single court decision, Transnor
(Bermuda) v. BP North America
Petroleum, that applied the CEA lo a
foreign market of mostly commercial to
commercial trarsactions. The
Commission did not believe these
transactions were Ihe off-exchange
"futures" contracts that Congress
intended lo prohibit and the
Commission Issued a statutory
interpretation to that effect. Obviously,
the parties in Ihe 15 day Brent Market-
major international oil and trading
companies — should not have been able
to escape their contractual obligations in
these transactions by claiming the
transactions were void as illegal futures
contracts.
Second, the Commission's new
exemptive authority granted by
Congress in the Futures Trading
Practices Act of 1992 frees the
Commission from the constraints of the
futures/forwards dichotomy. In this
regard the exemptive authority allows
the Commission to approach situations
on a case by case basis. This freedom to
try new approaches is the real value of
the exemptive authority. The
Commission is now able to review
petitions or requests for exemption on a
public policy basis In light of the
seventy year history of regulating
futures contracts as well as the current
and expected needs of commerce.
I believe that public policy dictates
that the Commission exempt the market
before us today from Commission
regulation. There does not appear lo be
any reason sufficient lo justify
Commission regulation, nor any
necessity for Ihe Commission lo Involve
itself in this market. I view this market.
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Federal Register / Vol. 58, No. 74 / Tuesday, April 20, 1093 / Notice*
21295
lu tianMctlooi, end peitidpanU u
clearly within the tcope intended by
CongreM for the exerdse of the
Commlulon't new exemptive authority.
Indeed, in enacting the exemptive
•uthority Congress specifically directed
us to address Uie crude oil market.
Soma have ai^jued that the
Commission should not exempt these
markets from the anti-fraud
requirements of section 4b of the CEA.
I disagree. First, in this commercial to
commercial market there has not been
shown any need for the Commission to
take any action to prevent fraud.
Second, >s the Commission will not be
Involved with ongoing regulation of this
market, or even be more than generally
knowledgeable of the activities in this
market, it will not possess the
information necesssry to enforce
Section 4b. Third, the presence of 4b
will be of little potential benefit and
great potential harm. The terms of 4b
limit its application to futures contracts
entered into for or on behalf of a
customer — serious limitations where the
transactions are largely principal to
principal and where the Individual
transactions would have to be proved to
be futures contracts. Further, If a party
to one of those exempt transactions were
to seek to base a complaint on Section
4b, they would face the problem that the
commission has also chosen to exempt
this market from section 22 of the Act,
thus they may not have any right to
bring a private action under the CEA.
The potential harm of maintaining 4b
jurisdiction Is that such action on one
Dand may hinder the development of
this market, undermining the legal
certainty we seek to assure today and on
the other hand give some the illusion of
federal supervision by the CFTC, when
in fact the CFTC does not and can not
supervise this market.
Exemptive Order for Certain Energy
Contracts, Concurring Opinion of
Commissioner Joeeph B. Ola]
AAer the enactment of the FTPA, we
find ourselves In the peculiar situation
of possessing an exemptive authority
that does not require our determination
that something Is a futures contract In
order to exempt if bom out jurisdiction.
At least that's what the conference
report language tells u«.
Accordingly, we have worked
diligently to avoid steppiiig on the legal
and policy land mine* Inherent In this
authority. I have gone over the new law
and the conference report, as well as the
case law end Commission
interpretations in the area of forward
contract deBnition. in light of concerns
regarding Section 4b of the Act and this
exemption, and the differing
Institutional opinions on this issue, I'd
like to make clear how I view this
exemption.
First, It Is understandable that people
ihake a comparison between the swaps
and hybrids exemptive authority this
commission exercised In January, and
the exemptive authority we are
approving today. We are new at this
endeavor, and so have little background
as an Institution in using this particular
authority. Therefore, I think It Is
Important to note some of the
dilTerences I see between today's
exercise and the exemptive action the
Commission took on January 14, 1993.
The forwards markets are understood
to be fundamentally different from the
swaps markets. In effectuating the
swaps exemptive authority, we did not
have the longstanding Institutional
experience that we do with forwards
markets and their evolution. Swaps are
a relatively new field of complex
financial transactions, and are still the
object of intense study by the
government and the private sector.
Therefore, the Commission deemed it
prudent to retain 4b so that, for
example. If In the unlikely event an
unscrupulous entity were to convolute a
swaps transaction into a boilerroom-
type futures transaction, we could act
expeditiously against such conduct.
Conversely, with the exercise of
exemptive authority as to the energy
contracts In current usage as described
In this proposal, we have extensive legal
and policy background relating to these
well-known commercial markets.
As my colleagues are aware, 1 take a
strong pro-enforcement stance In the
Investigation and prosecution of fraud
In the markets we regulate. However,
after reviewing the current request for
exemption for existing markets, and In
light of the Brent interpretation and the
continuing evolution of these
commercial transactions, I believe it
more proper, from a policy and legal
standpoint, not to retain 4b authority as
to contracts described In this
exemption. I came to this view after
Interpreting the conference report
language regarding the use of exemptive
authority In this area to Indicate a need
for clarincatlon of our Brent
Interpretation. While I recognize that
this exemption Is regarded as an
expansion of Brent, I view our action
here today to be in accordance with the
Congressional directives In the FTPA.
Therefore, I've concluded that 4b should
not be retained regarding exemptive
authority for existing practices In these
energy contracts.
If, after approval today, someone
commits a fraudulent act relating lo
what appears on the surface lo he an
exempt ane;gy transaction within tUi
proposal, but U proven latar to hia
futures contract outside the paramalara
of this proposal, then the COmmltsIon of
course nas authority to prosecute that
fraudulent conduct under 4b.
This exemption Is unique, given Its
factual and legal background. I believe
that by approving it we are exercising
our exemptive authority In a manner
consistent with Congressional Intent
We era allowing existing energy contract
practices in these markets, whose
historical record Is well-documented, to
continue to perform a useful function lo
the International marketplace.
Dissenting Opinion of Commlnionar
Sheila Bair
Mr. Chairman. I have decided, albeit
reluctantly, to vote against the final
order before us today because of Ila
failure to retain the general anti-fraud
provisions contained in section 4b and
4o of the commodity Exchange Act. Let
me Just briefly summarize the policy
reasons why I believe we should retain
such authority in the energy exemptive
order.
In my view, the final order, by its
terms, is not limited to forward
contracts traditionally excluded from
the jurisdiction of this agency. Rather, it
goes slgnificanlly beyond the forward
contract exclusion and extends to
transactions which could very well meet
the criteria for illegal off-exchange
futures contracts traditionally applied
by this agency and the courts. I Dellevs
that exempting such transactions from
statutory provisions as basic and central
to our regulatory scheme as Sections 4b
and 4o is a serious misapplication of our
new exemptive authority, and sets •
dangerous precedent.
The Proposed Order Goes Beyond the
Forward Contract Exclusion
As I stated, the order, by Its terms, U
not limited to forward contracts.
Further, the fact that we are proceeding
with an exemption from our
Jurisdiction, as opposed to describing a
class of excluded transactions,
demonstrates ImpUdt recwnltlon that
some of the transactions which we ara
exempting could indeed be future*.
Moreover, ^narkets which qualih fcr '
this exemption operate very diflerently
from traditional lorward markets. Tha .
contracts are standardized, there is a
large amount of speculative activity, and
the overwhelming majority of
transactions do not result Id delivery, ^■
but are cash fettled.
Indeed, tha only arguable
distinguishing feature between exeinfrt *
transactions under the order and tha
typical gasoline boiler room operation it
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Federal RejMer I VoV. 58, No. 74 / Tuesday. April 20. 1993 / NoUce«
the requirement that participants be
commenHal entities. Yet. the
"commeidalitr" requ lre ineirt in the
order is by and large uodeGned.
MoreoTer, the Commission, has nerer
recognized an exemption to its
jurisdiction based solely on the
"commerciality" of the participants, nor
can I see any policy reason why
commercial firms engaging in futures
transactions should not have the basic
protection of our anti&aud provisions.
The "SophistJcatios" of Market
Participants is Not a Vahd Basis for
Providing oa Anti-Fraud Exemption
II has beoi argued that because the
participants in exempt energy
transactions are "sopnislicated"
institutional users or entities of high net
worth. Ihey don't "need" CFTC anti-
fraud protections.
At the outset. T would note that if we
are to rationalize exemptions from anti-
fraud and other components of our
regulatory scheme on the basis of the
"sophistication" of market users, we
might as well close our doors tomorrow,
because approximately 98% of users of
regulated, exchange-traded futures meet
the eligibility rquirements of our swaps
rule, and, these financial requirements
are much higher than those in the order.
Moreover, large firms are defrauded —
we have brought a number of
enforcement actions where the victims
have been so-called inslitutional or
sophisticated investors. I would also
add that this order does allow for
indirect public participelion through
collective investment vehicles, ana
thro(4gh the guarantee provisions In
paragraph il of the appropriate person
portion of the order.
The Existence of State Aati-Fraud
Remedies is Irrelevant to the Issue at
Hand
In addition. I do not view the
existence of state anti-fraud remedies as
a valid policy basis for providing an
exemption from the CEA's basic anli-
fraud protections. State remedies are
always available in the absence of
federal protections. It Is Important to
remember that it was the historical
inadequacy of slate law protections,
however, ual gave rise to federal
regulation of flnancial markets in the
first placa
Retaining Sesklaal Anti-Fraud
Authority Would Not Place An Onerous
burden on the Uarket*
I also do not believe It»t we would
place an ODerous bnrden on the inailsU
by retaining anti-fraud autiiority.
If we retained 4b and 4o, Ihey would
apply to those fraudnlent transactiom
which we could demonstrate i
futures contracts and thus otherwise
subject to the CEA. In addition, since we
are preserving the Brent Oil statutory
interpretation, defendants would still be
able to rely on that document as a shield
against CfTX) actions. Moreover,
participants in these markets have
always run the risk that transactions
which do not meet the statutory
interpretation could be deemed
"futures" and thus subject to the whole
plethora of CEA requirements, not just
anti-fraud prohibitions. That is precisely
why we are moving forward witn this
order. Is 11 really that much of a burden
on market participants to retain a sliver
of authority r^arding fraudulent
activity?
It should also be emphasized that 4b
and 4o apply no more of an onerous
burden on these markets than does slate
anti-fraud law. Indeed, given conflicts
in stale law. providing federal forums
and remedies to these transactioas is. if
anything, less onerous.
Providing aa Anti-Fraud Exemption
Would Set a Dangerous Precedent and
Is Unnecessary Given Our New
Exemptive Authority
Finally, I think we are setting a
dangerous precedent by not retaining
anti-fraud authority. I can see no valid
policy reason why to decide lo retain
anti-fraud authority in our swaps rule,
yet lo declirte lo do so here. My fear is
that we win inevitably raise the
expectations of other potential
applicants for exemptive relief that they
will also be able to escape Sections 4b
and 4o.
What Is especially frustratinig lo me is
that we do aol oeea to paint ourselves
into this comer. The scaia raasoo why
the CFTC sought general examptiva
authority in last year's reauthorization
was so that we would have the
flexibility to craft appropriately lailored
exemptive relief based on public policy
considerations, instead of having lo deal
with the "all or nolhing" jurisdictiouil
decisions we had to make in the past.
Yet. we are still following this "all or
nothing" approach, when in my view,
we should be carefully weighing
individual aspects of our tegulalnry
striurlure and makiiig a raasooad
determination as to which requirements
shonld and should not ^ply loa
particular class of IraasacUons. And, for
the reasons 1 have stated, I do not
believe the case has been made lor
providing an exemption from basic anti-
fraud provlsioni.
IFR Doc 83-9037 Piled 4-19-93: 8:4S ami
Bajj<o COM nsi-oi-a
67
statement of Sheila Bair
Commissioner
Commodity Futures Trading Commission
Before the House of Representatives Committee on Agriculture
Sulscommittee on Conservation, Credit
and Rural Development
April 28, 1993
Mr. Chairman, members of the Subcommittee, thank you for the
opportunity to appear before you today to discuss the Commission's
recent order exempting certain energy contracts from the Commodity
Exchange Act. I voted against the exemptive order because it did
not retain the general anti-fraud provisions of the Act. I voted
as I did because I think that exempting these transactions from
statutory provisions as basic and central to our regulatory scheme
as Sections 4b and 4o is a serious misapplication of our new
exemptive authority, and sets a dangerous precedent. Before I
discuss the specific policy reasons underlying my view that the
Commission should retain such authority, I would like to discuss
some general issues related to the energy exemption.
At the outset, let me say that I believe that the Commission
had the statutory authority to grant energy contracts an exemption
from the provisions of the Commodity Exchange Act, including the
antifraud provisions of Sections 4b and 4o. Section 4(c) of the
Act, which was recently added, gives the Commission the authority
to "exempt any agreement, contract or transaction . . . that is
otherwise subject to subsection fa) . . . from any of the
requirements of subsection (a) or from any other provision of the
Act (except section 2(a)(1)(B)) if the Commission determines that
68
2
the exemption would be consistent with the public interest."
(emphasis added) .
Subsection (a) of Section 4 of the Act, referred to in the
Commission's exempt ive authority, requires that futures contracts
be traded on contract markets designated by the Commission. Thus,
under Section 4(c), the Commission has the authority to exempt
futures contracts from the provisions of the Act. The legislative
history to Section 4(c) makes it clear that Congress did not intend
that the Commission needed to make a determination that a product
is a futures contract before granting it an exemption from the Act.
However, any exemption granted by the Commission is effective only
to the extent that the product exempted is a futures contract
subject to the Act. The Commission's exemptive order for energy
contracts did not specify whether those contracts are futures. The
Commission's exemptive order did leave that possibility open and
is, in my view, effective to the extent that the energy contracts
at issue are futures.
Further, let me say that I did not oppose, in concept, some
type of exemption from the Act for the Brent crude oil contracts.
As the legislative history to Section 4(c) noted, one court in a
decision in Transnor (Bermuda) Limited v. BP North America
Petroleum , has found that these contracts are futures contracts.
The legislative history to Section 4(c) encouraged the Commission
to review the situation regarding Brent contracts and "to determine
whether exemptive or other action should be taken." Conf. Rep. at
82.
69
3
I was amenable to a properly tailored exemption for the Brent
market because I could see why uncertainty as to the legal status
of this market persisted after the Commission's September 1990
issuance of a Statutory Interpretation determining that Brent
contracts were forward contracts excluded from the Act. As former
Commissioner Fowler West's dissent to the Brent Statutory
Interpretation correctly points out, the Brent Statutory
Interpretation went far beyond generally accepted criteria in
defining Brent contracts as forward contracts. In the Brent
Statutory Interpretation, the Commission was forced to depart from
the traditional requirement that the parties to a forward contract
contemplate delivery and that delivery routinely occurs in order to
avoid concluding that Brent market transactions were illegal off-
exchange futures. The Commission had little choice but to take
such an approach to defining forwards, because it lacked the
authority to exempt futures contracts from the Act.
The Brent Statutory Interpretation, however, did not provide
the legal certainty that the Brent market participants sought. The
Brent Statutory Interpretation was such a departure from the
traditional view of forwards that it left open the possibility that
a court could disagree and find that Brent contracts were futures
contracts subject to the Act, in spite of the Commission's view
that they were not. I believe that this is exactly the type of
situation that the Commission's exemptive authority is meant to
address. Legitimate, ongoing commercial activity was being
threatened by uncertainty about the legal status of conducting such
70
4
activity off an organized exchange. The Commission could end that
uncertainty by granting an exemption from the Act. In such a case,
I believe that the proper course was for the Commission to grant an
exemption retaining, at the least, anti-fraud and anti-manipulation
authority. I would have supported an exemption for the Brent
market on these terms.
Retention of anti-fraud and anti-manipulation authority is
even more important to me in the context of the exemptive order
issued by the Commission because this order grants relief
significantly beyond the Brent market and the Brent Statutory
Interpretation. The Brent Statutory Interpretation was crafted to
address contracts for the delivery in the Brent oil market, where
a single cargo consists of 500,000 barrels of oil with a current
market value in excess of $10 million. The energy exemption, on
the other hand, encompasses any contract for the purchase and sale
of all types of crude oil as well as condensates, natural gas,
natural gas liquids or the derivatives of these commodities,
without regard to the size of the transaction.
Further, expansion of the types of contracts granted relief
necessitated expan^on of the types of offset arrangements
permitted under the exemption in order to reflect the practices of
markets other than the Brent market. The Brent Statutory
Interpretation described several alternatives to delivery: strings,
chains, loops and book-outs. These arrangements are all negotiated
subsequent to entry into a Brent contract. Because there is no
preexisting obligation to enter into such arrangements, parties to
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5
Brent contracts retain the risk that they will have to make or take
delivery in the absence of counterparty willingness to offset the
delivery requirement, and that someone, in fact, will always have
to take delivery of each Brent cargo.
The energy exemption permits these alternatives to delivery as
well as the use of master agreements established prior to entry
into an energy contract. Master agreements, used in some of the
markets covered by the exemption, provide that the two
counterparties agree to net energy contracts of the same commodity
at the same location and during the same delivery period. The
presumption under a master agreement is that all contracts between
the counterparties which cancel each other will net, unless the
parties agree not to apply the prior netting agreement at the time
of entry into an energy contract. Participants in these markets
that use master agreements can net all transactions in a particular
month, with no intention to take delivery of any amount of oil, and
no ultimate movement or change in ownership of the commodity .
In addition, the scope of entities eligible for the energy
exemption is significantly broader than those described in the
Brent Statutory Interpretation. The Brent Statutory Interpretation
described the participants in the Brent market as producers,
processors, refiners and merchandisers of petroleum products and
other entities that buy and sell petroleum in connection with a
line of business. The entities eligible to participate in exempt
energy contracts include, among others, banks, governmental
entities, including municipalities, corporations, partnerships and
72
6
proprietorships with a net worth exceeding $1 million or total
assets exceeding $5 million or the obligations of which are
guaranteed or supported by a line of credit from an eligible
entity, including a bank, savings and loan, broker-dealer or
futures commission merchant. A footnote to the exempt ive order
makes clear that commodity pools and other collective investment
vehicles as well as floor brokers and floor traders can be eligible
participants in exempt energy contracts so long as they meet the
net worth or guarantee requirements for business entities and
qualify as "commercials" for purposes of the order.
This expansion of eligible entities would not be so
significant if the commerciality requirement of the Brent Statutory
Interpretation had been preserved. However, this requirement has
been loosened considerably. The Brent Statutory Interpretation
emphasizes that transactions in Brent contracts are entered into
for commercial purposes in normal commercial channels and are
related to the business of the parties to the contract. These
parties were subject to substantial economic risk, including risks
related to delivery such as demurrage, damage, theft and
deterioration .
On the other hand, exempt energy contracts may be entered into
by "commercial participants who, in connection with their business
activities incur risks, in addition to price risk, related to the
underlying physical commodities." This sounds impressive, but a
publicly offered commodity pool or a floor broker with a partial
interest in a single oil well could, in good faith, claim that it
73
7
met the risk portion of the commerciality test. Indeed, it could
be argued that an entity could become a "commercial participant"
for purposes of the exemption simply by entering into an exempt
transaction. This is because the terms of an exempt energy
contract expose the parties to the contract to the risk of owning
the commodity. This circularity essentially nullifies the
commerciality requirement of the energy exempt ive order.
Related to the definition of commerciality is the capacity to
make or take delivery under the contract. In the Brent Statutory
Interpretation, the participants in Brent contracts were described
as having the capacity to actually make or take delivery of cargoes
of Brent crude oil. On the other hand, the Commission's energy
exemptive order permits participants to contract out for delivery
capacity and permits business entities that do not meet the net
worth requirements of the order to participate in exempt energy
contracts though guarantees provided by other business entities
which meet the net worth requirement, or by a bank, savings
association, insurance company, broker-dealer, futures commission
merchant which are not required to meet any net worth requirement.
Taken together, these provisions of the energy exemptive order
describe a system virtually identical to that used by traders who
trade on futures contracts with the benefit of a performance
guarantee provided by their carrying futures commission merchant.
In my view. Brent contracts, as described in the Brent
Statutory Interpretation, may well be futures contracts under the
traditional criteria applied by the courts and the Commission. The
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8
Commission's energy exemption is an expansion of the Brent
Statutory Interpretation in markets covered, delivery alternatives
permitted, market participants deemed appropriate, level of
commerciality required and the type of delivery capacity needed.
As a result, it is quite probable that many of these exempt
transactions are, in fact, futures contracts within the meaning of
that term developed by the Commission and the courts.
My conclusion that the energy order exempted futures contracts
from the provisions of the Act reinforced my view that, as a
general rule, the Commission should retain anti-fraud authority
whenever it grants an exemption under Section 4(c). As I will
explain, I was not convinced that, in the context of the energy
exemptive order, the case had been made for making an exception to
my strong preference that we retain anti-fraud authority in
exemptions. As a result, I dissented from the Commission's order
exempting energy transactions.
One of the primary arguments advanced for granting an
exemption to the anti-fraud provisions of the Act has been that the
participants in exempt energy transactions are "sophisticated"
institutional users or entities of high net worth who do not "need"
the anti-fraud protections of the Act. At the outset, I would note
that if we are to rationalize exemptions from anti-fraud and other
components of our regulatory scheme on the basis of the
"sophistication" of market users, we might as well close our doors
tomorrow, because approximately 98% of users of regulated,
exchange-traded futures are also "sophisticated" institutional
75
9
users or entities of high net worth. Moreover, the Commission has
never recognized an exception to its jurisdiction based solely on
the "sophistication" of market participant, nor can I see any
policy reason why sophisticated firms should not be covered by
basic anti-fraud provisions.
Additionally, we all know that large firms are defrauded.
The Commission has brought or assisted in a number of actions where
the victims have been so-called institutional or sophisticated
investors. For example, with the Commission's assistance, the
employee of a bank holding company was convicted of defrauding a
number of banks in Pennsylvania in connection with their futures
trading. Last summer, the Commission found that a regional
brokerage firm had engaged in unauthorized trading of the account
of a now-failed savings and loan with the assistance of an employee
of the S&L.
Further, as I have described, the Commission's exemptive order
permits participation in exempt energy transactions by
comparatively low net worth individuals or small businesses,
through the footnote permitting collective investment vehicle
participation, the $1 million net worth threshold for corporations
and proprietorships and the sweeping guarantee provision. The
participation of such entities not only undermines the
sophisticated institution argument for an exemption from the anti-
fraud provisions of the Act for energy transactions it also
increases the likelihood of exempt energy boilerrooms that target
small business. Finally, because the order fails to expressly
76
10
retain Section 4o authority, it is unclear if the Commission has
the authority to sue a registered commodity pool operator for
fraudulent representations to prospective pool investors concerning
the pool's participation in exempt energy transactions.
For all of these reasons, I was unpersuaded that an exemption
from the anti-fraud provisions of the Act could properly rest on
the types of participants permitted to use exempt energy
transactions .
Another argument made to justify an exemption from the anti-
fraud provisions of the Act is that retaining these provisions
would place an onerous burden on the energy markets. First, I must
emphasize that if the anti-fraud provisions of the Act had been
retained, they would only apply to fraudulent transactions. In
order to prevail, our Division of Enforcement would have to show
both that fraud occurred and that the transaction in question was
a "futures contract" subject to the jurisdiction of the Act. In
addition, participants in Brent contracts would still be able to
brandish the Brent Statutory Interpretation as a shield against
CFTC enforcement action because the energy exemptive order
preserved the viabilj.ty of that document.
It should also be emphasized that 4b and 4o apply no more of
an onerous burden on these markets than does state anti-fraud law.
Indeed, given conflicts in state law, providing federal forums and
remedies in connection with these transactions is, if anything,
less onerous than forcing participants, many of which are not U.S.
companies, to resolve their disputes under state law.
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11
Further, at least some of the energy contracts exempted by the
Commission are subject to a foreign regulatory scheme that appears
to be more onerous than retention of the anti-fraud provisions of
the Act would be. For example, 15-day Brent contracts are
considered "investment contracts" under the United Kingdom's
Financial Services Act, a category of contracts that includes
futures. The Financial Services Act contains limitations on the
types of customers who can participate in non-exchange traded
investment contracts, such as 15-day Brent contracts. The
contracts are also subject to an Oil Market Code of Conduct
promulgated by the Securities and Investment Board, a body which is
empowered to enforce the Financial Services Act. The Oil Code of
Conduct, among other things, prohibits the making of misleading
statements and misleading conduct in connection with 15-day Brent
contracts. The Oil Code of Conduct refers in this regard, to
Section 47 of the Financial Services Act, violation of which
constitutes a criminal offense punishable by up to 7 years
imprisonment or a fine or both.
In these circumstances, I did not see that it was much of a
burden on market participants to retain the anti-fraud provisions
of the Commodity Exchange Act.
I have also heard the argument that federal anti-fraud
remedies are unnecessary because state remedies remain available in
the absence of the anti-fraud provisions of the Act. I simply do
not view the existence of state anti-fraud remedies as a valid
policy basis for providing an exemption, from the Act's basic anti-
78
12
fraud protections. It is important to remember that it was the
historical inadequacy of state law protections that gave rise to
federal regulation of financial markets, including the Commodity
Exchange Act and the CFTC, in the first place. In view of these
concerns, I was not persuaded that state remedies provided an
adequate alternative to the anti-fraud provisions of the Act.
In addition, I could see no valid policy reason for
distinguishing the Commission's retention of anti-fraud authority
in the Commission's swaps rule from the failure to do so in the
energy exemptive order. Both swaps and energy contracts are
principal to principal contracts in which brokers are permitted to
facilitate transactions. Both permit letters of credit and
guarantees to substitute for net worth in determining the
eligibility of some participants. In fact, the asset thresholds
for eligible swap participants are significantly higher than those
required of eligible energy contract participants. Because the
energy exemptive order is broader than the swaps rule in allowing
low net worth individuals and businesses qualify to participate in
exempt transactions, the energy order would, if anything, seem to
present an even stronger case for retaining anti-fraud protections
than the swaps rule.
I also think that the Commission set a dangerous precedent in
not retaining the anti-fraud provisions of the Act in the energy
exemption. To my knowledge, it is unprecedented for the Commission
to provide relief from anti-fraud provisions for a transaction that
is not subject to the jurisdiction of another regulator. Even
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13
Commission rules governing trade options, which are options offered
to commercials in connection with commodities used in their
business, are subject to an antifraud provision. Retention of
anti-fraud jurisdiction is standard in exemptions granted by the
Securities and Exchange Commission, even those that involve very
high net worth investors. My fear is that the Commission has
raised the expectations of other potential applicants for exempt ive
relief, including the futures exchanges, that they will also be
able to escape Sections 4b and 4o. Remember, approximately 98% of
users of regulated, exchange-traded futures are sophisticated
institutional users or entities of high net worth.
Finally, I see the struggle over whether to retain anti-fraud
authority over exempt energy contracts as a sign that the
Commission is not yet taking full advantage of the flexibility
provided by our broad exemptive authority. I find this very
frustrating. The primary reason why the CFTC sought general
exemptive authority during its reauthorization was to give us the
flexibility to craft appropriately tailored exemptive relief based
on public policy considerations, instead of continuing to deal with
the "all or nothing" jurisdictional decisions that the Act required
in the past. I see the energy exemptive order as evidence that we
are still following this "all or nothing" approach when, in my
view, we should be carefully weighing individual aspects of our
regulatory structure and making a reasoned determination as to
which requirements should and should not apply to a particular
class of transactions.
Thank you.
80
statement of Joseph B. Dial
Commissioner
Commodity Futures Trading Commission
Before the
Subcommittee on Environment, Credit and Rural Development
April 28, 1993
Concerning the exemptive order for certain energy contracts.
Approved by the Commission April 13, 1993
As I stated in my concurring opinion to the exemptive order
relating to certain energy contracts, issued by the Commission on
April 13, 1993, I believe that this exemption was unique, given its
factual and legal background. In my comments on the 13th I
expressed the belief that Congress intended to allow existing
energy contract practices in these markets to continue to perform
a useful function in the international marketplace. I noted my
belief then, and respectfully submit to you today, that the
Commission was exercising its exemptive authority in a manner
consistent with Congressional intent.
From November 16, 1992 to April 13, 1993, I relied on the
plain language of the Futures Trading Practices Act and the
conferees' report as my guide in reaching a decision on the energy
proposal. There are seven factors explicitly stated in the statute
and conference report that I referred to time and time again:
1. The conference report to the Futures Trading Practices
Act of 1992 (FTPA), in a paragraph in the exemptive authority
section entitled "Forwards," specifically provided that "[T]he
conferees encourage the Commission to review this situation and
these contracts to determine whether exemptive or other action
should be taken." (FTPA, at 82).
81
2. The conferees indicated that the exemptive authority
should be used to "create legal certainty for a number of existing
categories of instruments which trade today outside of the forum of
a designated contract market." (FTPA, at 80) (emphasis added).
3. The conferees further stated that the Commission should
use the exemptive authority promptly in the "areas where
significant concerns of legal uncertainty have arisen," including,
among others, forwards. (FTPA, at 81).
4. The conferees specifically did not express a view
regarding the applicability of the Commission's Brent
interpretation. (FTPA, at 82).
5. The conferees expressly stated that the exercise of this
exemptive authority would not "require any determination before
hand that the agreement, instrument, or transaction for which an
exemption is sought is subject to the Act." (FTPA, at 82, 83).
6. The FTPA provides that the Commission may exempt an
agreement, contract, or transaction from Section 4(a) of the Act,
"or from any other provision of this Act (except section
2(a)(1)(B)), if the Commission determines that the exemption would
be consistent with the public interest." (FTPA, Section
502 ) (emphasis added)*.
7. The Conferees stated that the public interest test should
"include the national public interests noted in the Act, the
prevention of fraud and the preservation of the financial integrity
of markets, as well as the promotion of responsible economic or
financial innovation and fair competition." (FTPA, at 78).
82
Given each of these factors, it remains my determination that
the exemptive order as approved by the Commission was appropriate.
The conferees chose to allow our prior Statutory Interpretation
Concerning Forward Transactions , [1990-1992 Transfer Binder] Comm.
Fut. L. Rep. (CCH) § 24,925 (September 25, 1990 ) (hereinafter
referred to as the Brent Interpretation) to stand. Furthermore,
the language of the conference report clearly states that CFTC does
not have to find a contract within our jurisdiction in order to
exempt it. Accordingly, I voted to provide the requested relief to
existing "forwards-like" markets which could arguably come under
the penumbra of the Brent interpretation, believing we should treat
these more as "excluded forwards" than as "exempted futures." As
such, I made the decision that the application of Section 4b to
these contracts was inapposite.
I based this decision in part on my understanding of the
legislative intent regarding regulation of forwards contracts. The
Section 2(a)(1) exclusion for such contracts was grounded on the
premise that "the Act's regulatory scheme for futures trading
simply should not apply to private commercial merchandising
transactions which create enforceable obligations to deliver but in
which delivery is deferred for reasons of commercial convenience or
necessity." (Brent Interpretation, at 37,367). That
interpretation described the Commission's determination as to what
"commercial-to-commercial transactions involving commodities it
considers to be within the scope of the Section 2(a)(1) exclusion."
(Brent Interpretation, at 37,368). Included within that scope of
83
exclusions are "transactions [which] create specific delivery
obligations . . . [which] create substantial economic risk of a
commercial nature to the parties . . . ." (Brent Interpretation,
at 37,368) .
I believe that the contracts which were the subject of the
April 13, 1993 exemptive order were sufficiently within the
penumbra of the Brent Interpretation so as to warrant similar
treatment. These contracts are restricted to commercial entities,
and create delivery obligations that entail market risk. Even
though parties may enter subsequent contracts to discharge the
obligations (for example, agreements akin to the cancellation
agreements discussed in the Brent Interpretation), this does not
nullify the market risks attendant to these transactions.
Similarly, even though the parties may satisfy the capacity
requirement of the exemption by executing bona fide contracts for
services such as production, refining, or storage, this still
requires the ability to bear market risks involved with the
transactions .
Accordingly, I believe that the exemptive authority
sufficiently delimited the relief to existing markets which come
within the general category specified in the conference report
paragraph noted above, entitled "Forwards." This, I believe,
indicates that the fraud protection available to current
participants in the forwards market is sufficient for contracts
included in the exemptive order, and renders the application of
Section 4b inappropriate. I took this into account in reviewing
84
the various components of the public interest test, and I came to
the decision to support the energy exemption order as it was
approved after carefully reviewing the nature of the relief
requested, the existing markets, the above-mentioned directives of
the conference report and the statute.
85
April 9, 1993
MEMORANDUM
TO: Files
FROM: Andrea M. Corcoran
Division of Trading and Markets
RE: Exemption for Certain Contracts in Energy Products
This memorandum sets out reservations, which I have shared
with each Commissioner, concerning the draft Order that exempts
certain contracts from most provisions of the Commodity Exchange
Act--in particular, the anti-fraud provisions.^
The new flexibility afforded the Commission by the Futures
Trading Practices Act of 1992 provides welcome relief from the
need to make "all or nothing" decisions on the legality of
products subject to our jurisdiction. The opportuni*-y to reduce
current restraints on commerce and to permit markets to evolve,
however, does not alter the Commission's overriding
responsibility to protect the public interest.
As drafted, the exemption covers certain collective
investment vehicles and permits speculative transactions as well
as transactions based upon commercial need. The retail public
who might participate in such entities would be unlikely, absent
the blandishments of the salesman, to enter speculative
transactions in energy prices. Similarly, small comjnercials
would be unlikely to enter such transactions in the ordinary
course of their businesses.^
''l have signed the draft as consulted on behalf of the
Division of Trading and Markets, and many of ray suggestions have
been incorporated. Ultimately, however, policy concerns are
committed to Commission discretion.
^Among the public policy implications of developments that
the Commission is asked to specifically stxidy and report on to
Congress at the end of fiscal 1993 are those resulting from the
case of Krommenhoeck v. A-Mark Precious Metals, Inc . , 945 F.2d
309 (9th Cir. 1991). That case, by reference to the so-called
Brent Statutory Interpretation Concerning Forward Transactions
(55 F.R. 39188) found certain contracts to be both futures and
forward contracts and denied the relief sought with respect to
substantial losses suffered by small commercial customers.
Conference Report to accompany H.R. 707, H.R. Rep. No. 102-978,
102 Cong. 2d Sess. at 83.
86
To my knowledge, the Commission has never before exempted
transactions in products subject to its jurisdiction from the
anti-fraud provisions of the Act unless another regulatory regime
clearly applied to such transactions .■' In this case, energy
contracts exempted from the CEA would also be exempt from state
anti-bucketing laws and, to the extent that they are not
investment contracts or securities, or can be so designed, they
would be exempt from the securities laws as well.
By way of comparison, transactions in exempt securities--
including transactions by sophisticated investors (such as
qualified institutional participants with $100,000,000
portfolios) are not exempt from the anti-fraud provisions of the
federal securities laws. Further, in the United Kingdom,
certain transactions in the Brent Oil market itself are subject
to the criminal anti-fraud provisions of the Financial Services
Act (Section 47 (1)) and small commercial counterparties are
generally limited by law to transactions integral to their
businesses .^
By retaining anti-fraud jurisdiction to the extent
applicable, the Commission no more suggests that exempted energy
contracts may be futures (rather than forward) contracts than it
does by expressly acknowledging in the proposed release that the
Commission is not making a determination that these contracts are
not subject to the CEA or than the applicants have by requesting
an exemptive order from the exchange trading requirement for
futures .^
^Compare the treatment of swaps (anti-fraud provisions
retained) with the treatment of hybrid securities or depository
instruments (anti-fraud provisions relinquished in deference to
applicable federal and state securities and banking laws) in the
Commission's new Part 35 Rules.
^See e.g. . Section 10b of the Securities and Exchange Act of
1934 and Rule lOb-5; see also Preliminary Note i to Rule 144A) .
Also, as the result of failures of certain secondary dealers,
aspects of the government securities markets were regulated in
1986 and further regulation is contemplated as a result of the
alleged Salomon Brothers manipulation.
^See Appendix 2, Oil Market Code of Conduct of the
Securities and Futures Authority (SFA) Rule Book and SFA Conduct
of Business Rule 5-5.
^ See Division of Enforcement memorandum, dated April 8,
1993, to Gerry Gay concerning the scope of Section 4b. I would
make just one other point. Among the list of qualified
counterparties are certain entities which meet a net worth
($1,000,000) or a net assets ($5,000,000) test. The exemption
makes clear however that a guarantee of no specified amount can
be substituted for this minimum size and resources test and
potentially for the capacity to deliver. To the extent this
provision is included to permit participation by small
commercials in energy-related businesses it is unnecessary -
another provision does so. Separately, participation on organized
futures exchanges is largely commercial, and intermediary
guarantees and clearing guarantees substitute for the credit
judgments made in private transactions betweeen counterparties as
principals.
87
commodity Futures Trading Commission Implementation of
The Futures Trading Practices Act of 1992
SUBJECT
1 . Exemptive Authority-Swaps
2 . Exemptive Authority-Hybrids
3. Exemptive Authority-
Forwards
4 . Dual Trading
5 . Broker Associations
6 . Floor Trader Registration
7 . Ethics Training
8. Reparations /Class Actions
9 . Telemarketing
10. Insider Trading
11. Exchange Emergency Actions
12. Margin
13. Derivatives study
14. Risk Assessment
15. Suspension of Registrants
Charged with Felonies
16. Conflicts of Interest
17. SRO Governing
Boards/Disciplinary
Committees
18. Audit Trail
19. Penalty Study
20. Computerized Trading Study
21. Competitiveness Study
22. Oral Orders
COMMISSION ACTION
Final Rule (58 FR 5587, 1/22/93)
Final Rule (58 FR 5580, 1/22/93)
Final Order (58 FR 21286,
4/20/93)
Proposed Rules (58 FR 13025,
3/9/93)
Proposed Rules (57 FR 57116,
12/3/92)
Final Rules (58 FR 19575,
4/15/93)
Final Rules (58 FR 19575,
4/15/93)
Proposed Rules (58 FR 17369,
4/2/93)
NFA Rule 2-9 approved 1/19/93
Final Rule adopted 4/26/93
Federal Reserve Board delegation
to CFTC
Final Rules (58 FR 19575,
4/15/93)
Proposed Rules (58 FR 13565,
3/12/93)
Proposed Rules (57 FR 62244,
12/30/92)
TIMETABLE
(Statutory)
Promptly
Promptly
Promptly
270 Days
270 Days
180 Days
180 Days
270 Days
180 Days
36 Days
180 Days
None
One Year
Two Years
None
None
270 Days
Two Years
Two Years
Two Years
18 Months
270 Days
AMEND THE COMMODITY EXCHANGE ACT TO
ENSURE THE CONTINUED APPLICATION OF
THE ACT'S ANTIFRAUD AND ANTIMANIPU-
LATION PROTECTIONS
WEDNESDAY, JUNE 30, 1993
House of Representatives,
Subcommittee on Environment, Credit,
AND Rural Development,
Committee on Agriculture,
Washington, DC.
The subcommittee met, pursuant to call, at 10:15 a.m., in room
1302, Longworth House Office Building, Hon. Glenn English (chair-
man of the subcommittee) presiding.
Present: Representatives Long, Clayton, Barlow, Holden, McKin-
ney. Penny, Sarpalius, Peterson, Baesler, Farr, Gunderson, Allard,
Nussle, and Smith of Michigan.
Staff present: Vemie Hubert, chief counsel and legislative direc-
tor; Fred Clark, deputy chief counsel; John E. Hogan, minority
counsel; John Frank, deputy minority counsel; Glenda L. Temple,
clerk; Benjamin I. Baker, James E. McDonald, James A. Davis,
John Riley, and David Ebersole.
OPENING STATEMENT OF HON. GLENN ENGLISH, A REP-
RESENTATIVE IN CONGRESS FROM THE STATE OF OKLA-
HOMA
Mr. English. The hearing will come to order. A couple of months
ago this subcommittee held a hearing with regard to action that
was taken by the CFTC regarding the exemption of certain instru-
ments from the antifraud and antimanipulation provisions of the
Commodity Exchange Act.
While there is a question that remains as to whether or not there
is jurisdiction as far as the CFTC is concerned in some of these
areas, we felt that it was questionable as to the wisdom of giving
blanket exemptions on any authority that it may have.
So with that in mind, we have a hearing today with regard to
legislation to reinstate those provisions of antifraud and
antimanipulation protection. The legislation before us is H.R. 2374
and we have three witnesses today. We have Mr. Patrick Arbor,
who is chairman of the Chicago Board of Trade.
We would ask that he be our first witness today.
Let me also ask, is there any member who has an opening state-
ment that they would care to make this morning before we hear
from our first witness?
(89)
90
And for the record, although Mr. Donovan is well-known, we will
let you introduce Mr. Donovan if he is accompanying you.
Also, any prepared statements submitted by the members will
appear at this point in the record.
[The prepared statements of Mr. Farr, Mr. Combest, H.R. 2374,
and report from the Commodity Futures Trading Commission fol-
low:]
91
STATEMENT OF THE HONORABLE SAM PARR
UPON THE HEARING AND CONSIDERATION OF H.R. 2374
IN THE SUBCOMMITTEE ON ENVIRONMENT, CREDIT AND RURAL DEVELOPMENT
JUNE 30, 1993
Mr. Chairman and my fellow colleagues, it is a pleasure to join
you today for my first hearing and business meeting as the newest
member of the House Agriculture Subcommittee on Environment, Credit
and Rural Development. I want to thank you for allowing me the
opportunity to join you in working on issues of great importance to
the American farm economy.
The 17th District of California includes some of the most
bountiful farmland in the country and one of the most beautiful coast
lines in the world. My work in the California State Assembly included
protection of that beautiful coastal environment. As I continue my
work in this area, I look forward to my new tasks ahead as a federal
representative serving the people who provide the largest economic
base in my district, farmers.
In a world of diminished resources, international trade
agreements and banking reform, I know that the challenges the
Subcommittee face are great. I look forward to working with each of
you on formulating policy that benefits all farmers and Americans in
this country.
Thank you.
92
Statement of
the Honorable Larry Combest, M.C.
Subcommittee on Environment, Credit and Rural Development
Committee on Agriculture
June 30, 1993
Mr. Chairman, the hearing we had on April 28th convinced me that the matter of CFTC
exemptive authority was going to be a contentious issue. It was unfortunate, but not
surprising, that the three committees of jurisdiction in the House could not resolve all the
underlying issues last year during reauthorization of the Commission.
I note that our Committee has now received letters from the other two committees
concerned about H.R. 2374. Although I say this half in jest, I am beginning to think we
might have caused less harm had we simply moved forward with your proposal to define a
futures contract. Markets in exchange-traded and derivative products have become so
intertwined that the current, confused regulatory scheme is truly baffling to all but a few
commodity lawyers. I assume we are going to hear from some of them this morning. So I
hope to be enlightened.
While I understand your frustrations over this issue, Mr. Chairman, I did not hear April
28th nor have I heard anything since then that convinces me that this energy contract
exemption could cause the defrauding of an innocent public. I understand there are plenty
93
of innovative and unscrupulous people out there who may make me change my mind. But,
even if such activity takes place the Commission's enforcement chief recognizes the obstacles
the CFTC would face in bringing a case under the anti-fraud provisions of the Act. I assume
when the CFTC deals with fraudulent boilerrooms, the Commission must first prove the
contracts are illegal futures.
We certainly need to resolve these issues, and I look forward to working with you in the
months ahead once the various studies are in and we have heard from the experts. In the
meantime, it would be helpful if we could get a full complement of Commissioners and a
chairman that has the confidence of the current Administration and congressional
committees of jurisdiction.
72-584 0-93
94
103d congress
1st Session
H. R. 2374
To amend the Commodity Exchange Act to ensure the continued appHeation
of the Act's anti-fraud and anti-manipulation protections.
IN THE HOUSE OF REPRESENTATIVES
June 10, 1993
Mr. English of Oklahoma introduced the following bill; which was referred
to the Committee on Agriculture
A BILL
To amend the Commodity Exchange Act to ensure the con-
tinued appUcation of the Act's anti-fraud and anti-ma-
nipulation protections.
1 Be it enacted hy the Senate and House of Representa-
2 tives of the United States of America in Congress assembled,
3 SECTION 1. FUTURES ANTI-FRAUD PROTECTIONS.
4 The Commodity Exchange Act (7 U.S.C. 1, et seq.)
5 is amended by adding at the end the following new section:
6 "SEC. 23. RETENTION OF CERTAIN AUTHORITIES.
7 "(a) In General. — Except as provided in subsection
8 (b), to the extent that the Commission, by rule, regulation,
9 or order grants, or has granted, any exemption under sec-
10 tion 4(c)(1) for any agreement, contract, or transaction
95
2
1 (or class thereof), including an exemption for any person
2 or class of persons offering, entering into, rendering advice
3 or rendering other services with respect to the agreement,
4 contract or transaction, from any of the provisions of this
5 Act, such exemption shall not apply to the anti-fraud or
6 anti-manipulation provisions of this Act.
7 "(b) Exception. — The proscription in subsection (a)
8 with respect to the anti-fraud provisions of this Act shall
9 not apply to an exemption for any agreement, contract,
10 transaction, or person (or class thereof) to the extent that
1 1 such agreement, contract, transaction, or person (or class
12 thereof) is or will be subject to Federal securities or bank-
13 ing laws that provide comparable anti-fraud protection, as
14 determined by the Commission.".
15 SEC. 2. REGULATIONS.
16 The Commodity Futures Trading Commission shall
17 issue interim final regulations to implement the amend-
18 ments made by section 1 of this Act within sixty days fol-
19 lowing the date of the enactment of this Act. Such interim
20 final regulations shall include such amendments to any
21 rule, regulation, or order previously issued by the Commis-
22 sion as necessary to comply with the amendments made
23 by this Act.
HR 2374 IH
96
COMMODITY FUTURES TRADING COMMISSION
2033 K Street, N. W.. Washington, DC 20581
Williann P. Albrecht (202) 254 - 6970
Acting Chairman August 12, 199 3
The Honorable E (Kika) de la Garza
Chairman, Committee on Agriculture
U.S. House of Representatives
1301 Longworth House Office Building
Washington, D.C. 20515
Dear Mr. Chairman:
This is in response to your letter dated June 14, 1993
requesting the Commission's views on H.R. 2374, a bill to amend
the Commodity Exchange Act to ensure the continued application of
the Act's anti-fraud and anti-manipulation protections to
exemptions issued by the Commission under Section 4(c) of the
Act.
Please find attached the individual statements of myself and
Commissioners Bair and Dial setting forth our views on this bill
as presented to the Subcommittee on Environment, Credit and Rural
Development at its markup on June 20, 1993.
In your letter you ask us tok include the cost of enacting
this legislation for the current and next five fiscal years.
This is difficult to do without further indication of
Congressional intent. The bill would require the Commission to
reserve the antifraud and manipulation provisions of the Act in
each exemptive order the Commission has issued and will issue in
the future under section 4(c) of the Act. If the intent of the
legislation is not to expand the Commission's pre-existing
enforcement authority, we believe our existing enforcement
capability would be adequate to deal with these cases and there
should not be any significant cost increases in enacting this
legislation. If, on the other hand, the intent of the bill is
that the Commission develop an active oversight and surveillance
presence in markets where none has previously existed,
significant additional staff and resources will be required.
We appreciate this opportunity to present our views to the
Committee.
Sincerely,
William P. Albrecht
Acting Chairman
97
Statement of Dr. William P. Albrecht
Acting Chairman
Commodity Futures Trading Commission
Subcommittee on Environment, Credit and Rural Development
Committee on Agriculture
U.S. House of Representatives
June 30, 1993
Mr. Chairman, I welcome this opportunity to submit my views to you and members
of the Subcommittee on H.R. 2374, a bill which would prohibit the Commodity Futures
Trading Commission from exempting any transactions from the anti-fraud and anti-
manipulation provisions of the Commodity Exchange Act ("CEA"), except where the
exempted transactions were determined to be subject to comparable anti-fraud jurisdiction
under the Federal securities or banking laws. While I support the goals of preventing fraud
and manipulation, I cannot support this legislation which would restrict the flexibility just
recently granted to the CFTC. The need for this legislation has not been shown. In my
view, it would not significantly increase protection from fraud and manipulation. And,
despite its worthy goals, it could actually cause harm. Therefore, I urge you to proceed
cautiously so as to preserve the great strides made in the Futures Trading Practices Act of
1992 ("FTP A") after years of consideration in Congress.
Aiui-Fraud Need has Not Been Shown
I continue to believe the Commission has exercised its exemptive authority prudently
without exposing the public to increased risk of fraud or manipulation. Nevertheless, I
recognize your disagreement with the Commission's decision to exempt certain energy
contracts from the anti-fraud provisions of Section 4b of the CEA as you forcefully
expressed at your April 28, 1993 Subcommittee hearing. Certainly, it is legitimate to express
concerns about the possibility that the Commission's action opened the door to fraud;
however, I do not believe that we have done so. Nevertheless, the possibility, prevention
and prosecution of fraud are issues that should be addressed.
With regard to the exempt energy contracts, the Commission carefully considered
whether or not to exempt this market from the anti-fraud provisions of the CEA. Energy
market participants had not asked the Commission for enforcement assistance before the
exemption was granted, and I know of no problems since the exemption was granted.
The possibility of fraud was not ignored. In fact, one of the reasons the energy
exemption was limited to commercial, principal-to-principal transactions was to protect the
pubhc from potential boiler rooms. It is hard to imagine any boiler room style operation
dealing with the public which would not violate the terms of the exemption and thus be
subject to the full coverage of the CEA, to the extent it applied, including its anti-fraud
provisions and its prohibition against off-exchange trading.
98
In the unlikely event that some unanticipated fraudulent practices violating Section
4b within the scope of the energy exemption occur, the Commission is not left without
alternatives. Obviously, the Coimnission could amend the exemptive order to assert Section
4b authority over the exempt transactions (again, to the extent it applied). Or even better,
it could amend the exemptive order to leave the questionable transactions outside the scope
of the exemption altogether. In such a case the Commission would not need to prove fraud,
rather it need only show that the transactions were futures contracts not conducted on a
designated exchange and are thus illegal.
Finally, in addressing the need for CFTC anti-fraud jurisdiction, the alternative laws
available to police a given market should be considered. Indeed, H.R. 2374 recognizes that
CFTC fraud jurisdiction is not necessary when comparable securities or banking anti-fraud
laws exist. In my view, given the apparent absence of fraud in these transactions, existing
criminal and civil remedies are adequate to police these energy market transactions.
No Significant Benefits from Additional Anti-Fraud Law
Protecting market participants from fraud is of the highest importance to the CFTC,
as it should be to any regulator. In the exempt energy contracts, there were significant legal
and practical obstacles that more than offset any potential benefits of extending Section 4b
coverage to those contracts.
The initial obstacle to the application of Section 4b was that Section 4b applies only
to futures contracts and the vast majority of the energy contracts in question appeared to
be forward contracts under the Commission's 1990 Statutory Interpretation Concerning
Forward Transactions . In addition, by its own terms, the coverage of Section 4b is limited
to fraud committed by one person acting for or on behalf of another. Thus, Section 4b
apparently does not apply to the principal-to-principal energy contracts in question.
Besides the legal obstacles to the application of Section 4b there was the very real
practical problem that retaining Section 4b would have injected an illusion of Commission
supervision into a market where there was no ongoing regulation. Effective use of Section
4b may require an ongoing CFTC regulatory presence which would have created other
problems. After all, for the instruments it regulates the Commission maintains
comprehensive regulatory programs utilizing not only regulations and direct enforcement,
but also oversight of extensive programs of more than a dozen self-regulatory organizations
(SROs). To credibly maintain anti-fraud jurisdiction over exempt transactions the
Commission may believe that it is obligated to exert at least a modified regulatory presence.
Finally, the Commission just does not have the resources necessary to extend its regulation
to all these markets.
99
3
Real Burdens
In my April 28, 1993 testimony before this Subcommittee I expressed my concerns
that retaining Section 4b would do more harm than good. Rather than providing a potential
benefit, it would create legal uncertainty. I was concerned that, after having gone to great
lengths to assure foreign energy firms that they may engage in the normal business practices
that existed prior to the district court decision in Transnor (Bermuda) Limited v. BP North
America Petroleum . 738 F. Supp. 1472 (S.D.N.Y.) (" Transnor "). the presence of Section 4b
may say to some that the futures issue is not over. To some of these firms the mere
presence of Section 4b would have indicated that the CFTC is exerting some jurisdiction
over them and that more may follow. This was not an unreasonable view given that the
Commission had never regulated, nor sought to regulate, this market and that the market
was not then viewed as being within the scope of Section 4b. The legal uncertainty as to
whether the CFTC would in some way regulate these energy markets was reported to inhibit
the ability of U.S. firms to engage in international oil trading.
Even if there is disagreement on whether the Commission has acted appropriately
in a given situation, elimination of Commission flexibility would in itself have adverse
consequences. Flexibility is needed to deal with the innovations and problems of tomorrow
which we cannot predict today. It is that need for flexibility to enable the Commission to
allow, even encourage future innovations, that was the driving force behind Congress' grant
of exemptive authority just last year.
Exemptive Authority
In my view it is very important that H.R. 2374 be considered in the context of the
grant of exemptive authority to the Commission in the hi FA. In my April 28, 1993
statement submitted to you I noted the advent of new financial instruments in recent years
which contain both futures and non-futures elements. Analysis of these new financial
instruments placed the Commission in the jurisdictional dilemma of either forswearing any
jurisdiction at all over the instrument in question or requiring that it be traded on a
designated e.xchange. This dilemma faced by the Commission in turn caused great legal
uncertainty for the parties to transactions referred to as "swaps", "hybrids", and "cash settled"
forwards, and other commodity linked instruments which had futures-like characteristics.
The threat of legal uncertainty was highlighted by the district court decision in
Transnor : parties to transactions that had never before been considered futures contracts
now faced the prospect of having their transactions ruled void as off-exchange futures
contracts. The Commission responded to provide legal certainty to "Brent" market
participants and to parties to similar transactions, regardless of location or underlying
commodity, by issuing a statutory interpretation stating that the CFTC did not view these
transactions as futures, but rather as cash forward contracts, and thus excluded from
regulation under the CEA. Regretfully, this did not completely resolve the problem and
100
reportedly some international firms continued to refuse to do business with United States
based firms.
Fortunately, Congress was aware of the severe problems caused by the legal
uncertainty facing not only Brent market participants, but all parties to these new financial
instruments with futures-like characteristics. Congress recognized the need to provide
flexibility in this area and in the FTPA authorized the Commission to exempt any agreement
from the exchange-trading and most provisions of the CEA contingent upon certain
conditions. Those conditions include Commission determinations that the exemption is in
the public interest, that the agreement is between appropriate persons (such as institutional
participants), and that the agreement does not have a material adverse effect on the ability
of the Commission or any exchange to discharge its regulatory or self-regulatory duties.
Granting the Commission this exemptive authority was one of the most significant
amendments to the CEA by Congress in recent years.
As you know, there is no statutory definition of a futures contract. The legal
definitions relied on today largely come from Commission enforcement actions against
boiler room operations. The problems caused by application of those same definitions to
legitimate instruments with futures-like characteristics were one of the reasons exemptive
authority was needed.
One of the wisest decisions made by Congress in granting the Commission exemptive
authority was that exemptions do not depend on a determination that exempt transactions
are futures contracts. Some strongly disagree with the notion that the Commission can
exempt transactions not within its jurisdiction. I appreciate the rationale of this position,
but it ignores the history of why the exemption was necessary in the first place. The
exemptive authority was necessary because a whole new generation of instruments has
evolved that no longer clearly fit into the traditional regulatory categories.
Swaps are an excellent example of the need for legal certainty and the need for a
broad exemption. Swaps are limited to appropriate participants and serve the legitimate
financial management needs of firms all over the world, and yet many would say that
economically they are the equivalent of futures contracts traded on exchanges. Without
Congress' actions in the FTPA and the Commission's exemption, this entire market could
be upset by a future Transnor -like decision. Fortunately, Congress did not require the
Commission to decide whether swaps generally, or whether any swaps in particular, were
futures contracts before granting the exemption. As you consider H.R. 2374 I urge you to
recognize the need to provide the Commission with exemptive authority which is sufficiently
broad to foster the necessary degree of legal certainty for any particular market-including
markets that cannot be anticipated today. Only by doing so will Congress foster innovation
in the manner that I understood was the intent of the FTPA.
101
5
Manipulation
The concerns raised about eliminating Commission flexibility with regard to anti-
fraud jurisdiction also apply to manipulation jurisdiction. There does not appear to be a
need for retaining this authority, there will not be significant benefits gained by retaining
it generally and there are very real burdens to be placed on the exempt markets. In the
case of swaps, hybrids and energy contracts, the Commission retained limited anti-
manipulation authority. For instance, under the swaps exemption the Commission can take
action against a swaps dealer for using swaps contracts to manipulate the futures market,
or the underlying cash market, but the Commission did not retain the authority to take
action against a swaps dealer for manipulating the swaps market. After all, swaps are less
susceptible to manipulation since they are cash settled without a common expiration. The
Commission maintains an extensive surveillance and reporting program in conjunction wath
the SROs designed to address manipulation problems well before they are allowed to
develop. The Commission does not have such programs in place in the swaps market.
Arguably some such program would be needed to exercise anti-manipulation authority in
the swaps market itself.
Overlapping Jurisdiction
I appreciate the fact that one of the goals of H.R. 2374 is to coordinate the coverage
of Federal commodities law with Federal securities law and Federal banking law. While I
agree that the CFTC should consider comparable anti-fraud provisions in Federal securities
and banking laws, those are not the only sources of anti-fraud laws. For example, criminal
laws enforced by the Department of Justice, including wire and mail fraud statutes, are
frequently used in commodities fraud cases, even where the CEA is also applicable.
Additionally, state laws may in themselves be sufficient to police some markets.
Before concluding, I would like to comment on the legitimate interest of the states
in seeking to protect their citizens from fraud. I am confident that the Commission will
continue to assist the states in their efforts to protect their citizens. Further, I look forward
to continued dialogue with state regulators that will foster effective enforcement.
In conclusion, while I cannot support H.R. 2374, I appreciate the opportunity to
discuss my views. I trust that full consideration of this legislation will clarify Congressional
intent on the scope of the Commission's exemptive authority.
102
statement of Sheila C. Bair
Commissioner
Commodity Futures Trading Commission
Before the House of Representatives Committee on Agriculture
Subcommittee on Environment, Credit
and Rural Development
June 30, 1993
Mr. Chairman, members of the Subcommittee. Thank you for the
opportunity to appear before you today to discuss H.R. 2374. I am
pleased to express my support for this legislation, which is
designed to ensure that the anti-fraud and anti-manipulation
provisions of the Commodity Exchange Act will remain applicable to
transactions exempted by the Commission from other provisions of
the Act. I believe that the anti-fraud and anti-manipulation
provisions of the Act are basic and central to our regulatory
scheme. My views in this regard are set out in more detail in my
testimony presented before this Subcommittee on April 28, 1993. I
only regret that legislation which limits the Commission's
exemptive authority appears to be necessary to maintain the
applicability of these provisions of the Act.
I agree with the approach of H.R. 2374 as to when the
Commission should retain the anti-fraud and anti-manipulation
provisions of the Act and when sound public policy considerations
indicate that — in very limited circumstances — an exemption from
the anti-fraud provisions of the Act is appropriate. Consistent
with H.R. 2374, the only circumstance in which I believe that an
103
exemption from the anti-fraud provisions of the Act would be proper
is when the transactions or persons exempted are subject to the
jurisdiction of the SEC or the federal banking regulators.
One issue which the Subcommittee may wish to consider is
whether the bill should identify the specific sections of the Act
that comprise the Act's anti-fraud and anti-manipulation
provisions. The failure to specify which provisions of the Act the
Commission must retain when it grants an exemption may lead to
further misunderstandings between the Commission and the
Subcommittee .
Alternatively, the bill could direct the Commission to draft
and adopt special anti-fraud and anti-manipulation rules of general
applicability to all exempted instruments. This is the approach
the Commission has followed under its plenary authority over
options in retaining anti-fraud authority over exempted trade
options. See, Commission Rule 32.9, 17 C.F.R. § 32.9. Such rules
could apply across the board to all transactions exempted from the
Act by the Commission. Such an approach would uniformly preserve
the Commission's ability to put a stop to fraudulent activities
involving futures transactions, regardless of whether the
transactions fall within the parameters of an exemption the
Commission has granted.
104
Adoption of general anti-fraud and anti-manipulation rules for
exempted instruments and persons would put all applicants for an
exemption on notice that these crucial requirements will not be
waived. This approach would free the Commission to make a reasoned
determination about which aspects of our regulatory structure
should continue to apply to an instrument or activity for which an
exemption is sought without wasting time and energy debating the
advisability of preserving anti-fraud authority in a particular
case.
As previously stated, I think it is appropriate that the
legislation gives the Commission the flexibility to grant
exemptions from the anti-fraud provisions of the Act where it
determines that the relevant transaction is subject to the Federal
securities or banking laws. This is a determination that the
Commission is competent to make. However, once the Commission has
determined that a particular transaction is subject to a sister
regulator's jurisdiction, this should be sufficient. It is
unnecessary, to my mind, to further require a determination as to
whether the other regulator's anti-fraud protections are
"comparable." For this reason, I suggest that this concept be
stricken from H.R. 2374.
Although I have referenced a few technical concerns in my
testimony which the Subcommittee may wish to consider, overall, I
believe that H.R. 2374 will achieve the important goal of ensuring
105
that the anti-fraud and anti-manipulation protections of the Act
continue to apply to transactions exempted by the Commission from
other regulatory requirements. Preserving such authority in no way
implies that particular types of exempted off -exchange transactions
such as traditional swaps or 15 day Brent Oil contracts are in fact
futures contracts subject to CFTC jurisdiction. On the contrary,
it simply reflects the difficulties in crafting exemptive relief
broad enough to accommodate the legitimate needs of existing OTC
markets without providing a loophole for those who might try to use
an exemption as a shield against CFTC enforcement actions.
Preserving anti-fraud and anti-manipulation authority will ensure
that the CFTC continues to have the tools it needs to protect the
public interest.
106
statement of Joseph B. Dial
Commissioner
Commodity Futures Trading Commission
Before the House of Representatives Committee on Agriculture
Subcommittee on Environment, Credit,
and Rural Development
June 30, 1993
Thank you for the opportunity to comment on H.R. 2374. I will
not reprise my comments of April 28, 1993, on this subject,
inasmuch as they are a matter of record and I have not altered my
position .
If Congress passes H.R. 2374, then I will do all that is
within my power as a Commissioner to see to it that Commodity
Futures Trading Commission (CFTC) complies with the provisions of
this legislation. However, I respectfully submit my considered
opinion on the consequences of passage of H.R. 2374.
First, the intent of Congress in passing the Futures Trading
Practices Act (FTPA) of 1992, as expressed by the conferees, is
that, among other provisions, the Commission should use the
exemptive authority promptly in the "areas where significant
concerns of legal uncertainty have arisen," including, among
others, forwards. (FTPA, at 81).
If passed, H.R. 2374 will remove the legal certainty that the
CFTC exemptive order provides, because H.R. 2374 will apply a
futures antifraud provision to forward contract circumstances. If
H.R. 2374 becomes law, the energy sector will be right back where
they were after the court handed down the Transnor decision and
CFTC subsequently issued its Brent Oil Interpretation. H.R. 2374
107
will put a cloud of legal uncertainty over the head of energy
industry participants who wish to use these forward contracts
without assuming the legal risks of trading legally ambiguous
contracts which would expose them to an inappropriate regulatory
scheme .
If Congress decides to pass H. R. 2374 and do a 180-degree
turn from the position it took in the 1992 FTPA, that is their
prerogative. The members should know, before they make such a
move, that their action will impact the free market characteristic
of business participation based on economic incentive. As a
result, the cost of doing business in energy products may well
increase and ultimately the taxpayer will have to foot the bill for
unnecessary government intervention.
Forward contracts have been used in the normal course of
commerce for a century. There is absolutely no historical evidence
to prove that these transactional instruments have been a
convenient ruse used by devious charlatans to defraud "mom and pop"
retail customers. As of this date, no one has put forth a
plausible scenario whereby the exempted energy contracts would
subject the public interest to fraudulent schemes.
Granted, there are those who ascribe to the theory that this
exemption will allow for general public participation through the
use of pools, trusts, or partnerships, and the CFTC would not be
able to use the 4b fraud provision to prosecute fraudulent activity
in these circumstances. That is not the case.
In order for a collective investment vehicle to qualify for
108
this exemption, it must satisfy all of the appropriate person
requirements. Also, it can't be formed solely for the purpose of
qualifying for the exemption. If any of these requirements are not
met, the exemption is not applicable, and Section 4b fraud
authority could be available. In addition, the exemption provides
that Section 4o will continue to apply to commodity pool operator
fraud.
It is important to understand that the appropriate person
language in the CFTC energy exemption requires business proprietors
to have a net worth of $1,000,000 or total assets exceeding
$5,000,000, in order to become an eligible participant.
Furthermore, only commercial entities are allowed to engage in the
transactions covered by the energy exemption. As has always been
the case, if any commercial entity, large or small, is victimized
by fraudulent forward contract activity by its commercial
counterparty, then the plaintiff may address such conduct through
state law remedies. Accordingly, state fraud remedies clearly are
available to participants involved in exempted energy transactions.
Commodity Exchange Act (CEA) remedies are inappropriate, because
Congress has excluded forward contract activity from CEA
jurisdiction.
As further evidence of this fact, consider that in the 1992
FTPA, the conferees specifically did not express a view regarding
the applicability of the Commission's Brent interpretation. (FTPA,
at 82). Also, the conferees expressly stated that the exercise of
this exemptive authority would not "require any determination
109
beforehand that the agreement, instrument, or transaction for which
an exemption is sought is subject to the Act." (FTPA, at 82, 83).
Taken together, these two actions continue to position the forwards
markets in the same light as CFTC viewed them, i.e., as being
excluded from the Commission's jurisdiction. Consequently, CFTC
cannot apply 4b, a futures regulatory provision, to exempted energy
forwards .
If H.R. 2374 is enacted, then participants in exempted energy
contracts will run the risk of a disgruntled counterparty having
the option of reneging on its obligations by declaring an exempt
forward transaction to be an illegal off-exchange futures contract,
and having the panoply of futures market regulation applied to
them. This clearly is not what Congress intended to happen when it
passed the Futures Trading Practices Act of 1992.
110
STATEMENT OF PATRICK H. ARBOR, CHAIRMAN, CHICAGO
BOARD OF TRADE, ACCOMPANIED BY THOMAS R. DONOVAN,
PRESIDENT AND CHIEF EXECUTIVE OFFICER, AND MARK
YOUNG, COUNSEL, KIRKLAND & ELLIS
Mr. Arbor. Thank you, Mr. Chairman, and members of the sub-
committee. My name is Patrick Arbor and I am the chairman of the
Chicago Board of Trade. I am accompanied, as you noted, Mr.
Chairman, by Thomas Donovan, the president and CEO of the Chi-
cago Board of Trade, and Mark Young with the firm of Kirkland
& ElHs, who is our legal counsel.
Thank you for your invitation to present the views of the Chicago
Board of Trade on H.R. 2374 and the exemptions the Commodity
Futures Trading Commission has granted. As set out in my written
testimony, the board of trade generally supports H.R. 2374.
Antifraud and antimanipulation are core protections that should
apply to every transaction under the Commodity Exchange Act. We
have suggested certain technical changes to H.R. 2374 to strength-
en its provisions, but I am a businessman, not a lawyer, and rather
than discuss those technical issues today, I would be happy to
make our staff available to the subcommittee.
Mr. Chairman, like others, the board of trade could have just
submitted our written views to you. We chose, however, to appear
in person today to underscore our profound disappointment with
the CFTC's exercise of its exemptive powers.
The issue is very simple. In granting the CFTC exemptive pow-
ers. Congress told the CFTC, "to promote fair competition." That is
a quote from the statute. Congress told the CFTC to apply its ex-
emptive powers in, "A fair and evenhanded manner to products and
systems sponsored by the exchanges and nonexchanges alike."
Congress told the CFTC to use, "The least anticompetitive means
of exempting persons or transactions from the provisions of the
act." These are all quotes from the act.
Some 8 months have passed since the legislation became law. In
that time, the CFTC has ignored those congressional mandates.
The CFTC has refused to allow the exchanges to offer exempt in-
struments, swaps, energy contracts, under the same class of ex-
emptive relief it has willingly provided to the dealer markets.
The result of these policies is the worst kind of unfair competi-
tion. Over-the-counter dealer trading is exempt from regulation,
but exchange trading is subject to ever increasing regulatory cost
and restrictions. If the trend continues, exchanges will not survive.
They will lose the competitive battle to the over-the-counter mar-
kets and to foreign exchanges that enjoy nurturing relationships
with their regulators.
Indeed, we have done some work in Chicago and have discovered
that a customer opening up an account in the United States may
have to sign as many as 20 different documents, suitability require-
ments, disclosure requirements. A same customer opening up an
account in London or Paris may only have to sign two documents.
The documentation, the compliance, is becoming just too onerous.
But let me be clear, Mr. Chairman. The board of trade does not
want the over-the-counter market to be regulated beyond the fraud
and manipulation protections that your bill would impose. We are
comfortable with that. That kind of regulation is quite adequate for
Ill
professional markets where the only traders are sophisticated par-
ties who can protect themselves, but exchanges should have the op-
portunity to offer exempt professional markets too.
The CFTC to date has denied us that opportunity. The CFTC's
policy also precludes clearing of exempt instruments, a process that
we feel would strengthen the financial integrity of over-the-counter
derivatives; indeed, many feel this. This is possibly the most bi-
zarre aspect of the CFTC's policy.
Consider this: Since 1976 the CFTC has found that clearing is
essential for any new futures or options contract. Without clearing,
the CFTC has said it would disapprove trading, "As contrary to the
public interest."
For exempt instruments, however, the CFTC has prohibited
clearing and says that prohibition is, "Consistent with public inter-
est."
Now, maybe I haven't been in Washington long enough, Mr.
Chairman, but I can't figure out how something can be contrary to
and consistent with the public interest at the same time. That kind
of logic escapes us. Yet that is exactly the policy the CFTC has
adopted on clearing.
Mr. Chairman, Will Rogers once wrote, everything is funny as
long as it is happening to someone else. I guess the CFTC's incon-
sistent and incoherent exemptive policies might be funny except for
the fact they aren't happening to somebody else; they are happen-
ing to us.
The CFTC is denjdng futures exchanges the fair competition
Congress intended, while also denying market users the benefits
exempt exchange trading would offer, price transparency, liquid
trading, low regulatory costs, and financial integrity through clear-
ing.
The CFTC, however, will have a chance soon to remedy this situ-
ation. The board of trade has decided to file an exemptive applica-
tion for professional trading markets. As proposed, a professional
trading market would be exempt generally from CFTC regulation
subject to four basic conditions. One, only professional traders, not
small, retail customers would be allowed; two, the board of trade
operating the market must notify the CFTC before the operations
begin; three, fraud and manipulation prohibitions apply as well as
private damage actions; and four, all trades must be submitted to
a CFTC-approved clearing system.
The professional trading market exemption would promote both
responsible financial innovation and fair competition between ex-
changes and over-the-counter markets, the very purpose Congress
cited when it gave the CFTC exemptive powers. Therefore, we will
ask the CFTC to approve this proposed exemption immediately.
In conclusion, Mr. Chairman, the CFTC has thus far ignored the
fair competitive mandate that you and others in Congress enacted.
Our proposed professional trading market exemption affords the
CFTC another chance to follow your mandate.
In any legislation you adopt dealing with the CFTC exemptive
authority, we urge you to reaffirm the agency's duty to promote fair
competition and to do so in terms that the Commission may no
longer ignore.
Thank you, Mr. Chairman.
112
[The prepared statement of Mr. Arbor appears at the conclusion
of the hearing.]
Mr. English. Thank you very much, Mr. Arbor, I appreciate
that.
You mention that there were certain suggested changes that you
would recommend pertaining to the language of the bill. Are those
technical in nature that you are referring to or are they more sub-
stantive?
Mr. Arbor. They are technical in nature.
Mr. English. So from a substantive standpoint, you have no sug-
gestions with regard to change in the legislation; is that correct?
Mr. Arbor. No. Generally we agree with the bill.
Mr. English. Now, the point that again I want to stress here is
that the purpose of this legislation is not to reach beyond the juris-
diction the CFTC may have. That is, with regard to many of these
instruments or decisions that will have to be made at a later time,
but we do not want to send a signal that in any way a regulatory
body of the U.S. Government is withdrawing from its dealings and
responsibilities pertaining to fraud or antimanipulation.
I think that would be the wrong signal to send to any market
that may be under the jurisdiction of a Federal regulator. So I ap-
preciate your testimony and recognize that the points that you
were making in referring back to the reauthorization bill were well
taken. I am hopeful that we will see the CFTC pursue a course of
evenhandedness and fairness to all who may come under their ju-
risdiction, and all of the various markets, whether they be on ex-
change or off exchange.
So I appreciate that very much.
Mr. Allard.
Mr. Allard. Thank you, Mr. Chairman.
I am curious, from your perspective, do you think the CFTC has
the resources and the expertise to adequately police the antifraud
jurisdiction?
Mr. Arbor. If they have the resources and the authority to do
it for the exchanges, we think they certainly would have it for the
over-the-counter market.
Mr. Allard. Thank you.
That is all I have, Mr. Chairman.
Mr. English. Mr. Holden.
Mr. Holden. No questions.
Mr. English. Ms. McKinney.
Ms. McKinney. No questions.
Mr. English. Mrs. Clayton.
Mrs. Clayton. No.
Mr. English. Mr. Baesler.
Mr. Baesler. No.
Mr. English. Mr. Farr.
Mr. Farr. No.
Mr. English. Mr. Sarpalius.
Mr. Sarpalius. No questions.
Mr. English. You get off light today, gentlemen. Thank you very
much, we appreciate your testimony.
Our next witness is Mr. R. Wayne Klein, who is a securities bu-
reau chief for the State of Idaho and he is representing the North
113
American Securities Administrators Association here in Washing-
ton.
Mr. Klein, we want to welcome you here today and would be
happy to receive your testimony.
STATEMENT OF R. WAYNE KLEIN, CHIEF, SECURITIES BU-
REAU, STATE OF IDAHO, ON BEHALF OF THE NORTH AMER-
ICAN SECURITIES ADMINISTRATORS ASSOCIATION, INC.
Mr. Klein. Mr. Chairman, members of the subcommittee, good
morning. My name is Wayne Klein. I am chief of the Idaho Securi-
ties Bureau and a member of the board of directors of the North
American Securities Administrators Association, NASAA, on whose
behalf I appear this morning.
In the United States, NASAA is the national voice of the 50
State securities agencies responsible for investor protection and ef-
ficient functioning of the capital markets at the grassroots level.
NASAA and its members work closely with the Commodity Futures
Trading Commission and the National Futures Association in com-
batting commodity-related fraud.
Mr. Chairman, members of the subcommittee, I appreciate the
opportunity to appear here this morning in support of H.R. 2374,
legislation now under consideration by the subcommittee which
would amend the Commodity Exchange Act to ensure the contin-
ued application of the act's antifraud and antimanipulation protec-
tions, even in those instances where exemptions from regulatory
oversight otherwise are granted.
We commend the subcommittee for addressing this critically im-
portant issue. We also would urge you to turn your attention to
what we believe is a more general and disturbing trend at the
CFTC: Abandonment and repudiation of its responsibility to protect
the integrity of the commodity futures markets and those who in-
vest there.
The intolerable situation we find ourselves in today is a direct re-
sult of the regulatory philosophy and actions of the Commission's
leadership in recent years. It is not reflective of the work of the
Commission's dedicated staff which deserves credit for its investor
protection efforts.
The CFTC's recent order with respect to exempting certain en-
ergy contracts from regulatory oversight, including the antifraud
and antimanipulation provisions of the Commodity Exchange Act is
just the latest of what perhaps may be best characterized as the
agency^s reluctance to regulate, even in the face of blatant threats
to investors and to the integrity of the markets.
Worse yet, the Commission has vigorously guarded what it be-
lieves to be its turf, only to turn around and severely limit its own
role in what would appear to be a philosophy of, we won't police
the area, but we don't want anyone else to either. It is the hope
of NASAA and its members that such an approach will not persist
and instead Congress and the Clinton administration will use their
considerable authority to reenergize the agency with a clear sense
of its original mission and purpose.
As a former enforcement attorney and a State securities commis-
sioner, I have had personal experience observing the devastation
that can occur in the lives of those who are particular victims of
114
fraudulent commodity schemes. I myself have heard the outrageous
lies contained in their telephone solicitations.
I have litigated with those companies offering programs that
steal money from unsuspecting victims. In many cases the promot-
ers were able to defraud the victims only because the victims — in-
vestors believed that these investment vehicles were subject to sub-
stantial Government oversight.
Based on my experience and as detailed more fully in my written
statement, I feel that the CFTC is not performing the supervisory
and law enforcement task contemplated in the legislative history of
the Commodities Exchange Act. This inaction contributes to the
fraud that is already occurring.
Mr. Chairman, members of the subcommittee, without active and
vigorous oversight, the markets under CFTC exclusive jurisdiction
will invite fraud and abusive trading. While the States are commit-
ted to detecting and prosecuting fraudulent operators in this arena,
our role under the Commodity Exchange Act is very limited.
As a result, we respectfully would recommend that this sub-
committee seriously consider the following six point action plan for
reinvigorating the CFTC as an active and effective regulator of the
commodity futures marketplace.
First, Congress should immediately move to pass H.R. 2374. This
bill is absolutely necessary to mandate preservation of antifraud
and antimanipulation authority even in those instances where reg-
ulatory exemptions otherwise are granted. The provisions of the
bill should apply on a retroactive and prospective basis.
Second, the CFTC should be directed to withdraw its counter-
productive 1990 Brent statutory interpretation. In doing so, the
regulatory scheme governing the futures markets would revert to
the guidelines and criteria articulated by the Congress and by ear-
lier court decisions.
Third, Congress should consider requiring the CFTC to provide
a reasonable scheduled review of this latest energy related exemp-
tion, then require each entity seeking use of the exemption to make
a separate, publicly available application for exemption.
Each application should be accompanied by an explanation as to
how the participant and the contemplated transactions satisfy the
criteria set forth in the Futures Trading Practices Act.
Fourth, the CFTC should be directed to take great care in grant-
ing exemptions on a broad, generic basis without knowing who will
be taking advantage of the exemptions. This may help reduce the
potential for the exemptions to be used by crooks. It also would
provide information to the CFTC about off-exchange trading with
which to evaluate the effects of the exemption. Moreover, it makes
publicly available such economic factors as the volume of, the price
of, and parties engaged in, such trading.
Fifth, Congress should require the CFTC to embrace the policies
set forth in the FTPA conference report accompanying the Com-
modity Futures Practice Act with respect to distinction between fu-
tures and forward contracts, the continued validity of prior case
law establishing the futures contract definition and the jurisdiction
of other regulators.
And sixth. Congress should consider prohibiting the CFTC from
granting any exemption from its oversight for transactions which
115
are similar in nature to those currently traded on the regulated ex-
changes. This may help reduce the migration of trading away from
the exchanges, a trend which NASAA believes is contrary to the in-
terests of the economy and the integrity of those vital markets.
Mr. Chairman, members of the subcommittee, the futures mar-
kets today are recognized at home and abroad as a vital part of the
financial services industry. It is critically important that these
markets remain as free as possible from fraud and manipulation.
As exclusive overseer of the futures markets, the CFTC alone has
the authority to set the tone of regulation in this arena. If the
CFTC fails to assert or exercise its jurisdiction, other regulators
have only limited power to act and then may act only after viola-
tions have occurred.
NASAA and its members look forward to working with you and
other Members of Congress to take the steps necessary to restore
the CFTC to its original mission and purpose.
I thank you for this opportunity to express the views of NASAA.
I am happy to answer any questions you may have.
[The prepared statement of Mr. Klein appears at the conclusion
of the hearing.]
Mr. English. Thank you very much, Mr. Klein. I appreciate your
testimony.
We were told when the CFTC appeared before us earlier in the
discussion with regard to this exemption that as far as any fraud
is concerned, that States have fi'aud laws, and so therefore there
is really not any problem, that the States could simply use their
fi*aud laws to deal with any violations that might occur, any in-
stances of fraud that might occur with regard to this market.
Could you give us your views with regard to that possibility?
Mr. Klein. Mr. Chairman, we appreciate the CFTC being so gen-
erous with providing work for us, but there are a number of rea-
sons why we think that is a very inadequate solution.
One is that the CFTC is the one who truly has the expertise in
this area and to say the States can use their general common law
fraud statutes to apply is not going to give us the ability to go after
the kind of frauds we ought to.
Also, the laws are not as specialized enabling us to go after par-
ticular suitability or misrepresentations without proof of an intent
to deceive.
Second, only the CFTC has authority under the Commodity Ex-
change Act to enforce the Commodity Exchange Act on a nation-
wide basis. Yes, individual States can take action and can even
shut down the fraud, but they will have to do it on a State-by-State
basis, and we think it is inappropriate to require 30 or 50 States
to take action in order to shut down a program operating nation-
ally.
In addition, they are relying on us, the States, to bring enforce-
ment action to remedy problems that could more easily be rem-
edied by some restrictive requirements on the trading beforehand
that prevents the fraud from occurring rather than saying, yes,
when you find the fraud, please go after the people who commit it
and put them in jail because the investors have still lost money.
Mr. English. I am not an attorney, but it is my understanding
that under the Commodity Exchange Act the States are preempted
116
from the standpoint of any kind of State laws that might exist in
dealing with violations under the Commodities Exchange Act. Is
that correct?
Mr. Klein. Mr. Chairman, for the most part, that is entirely cor-
rect. Unlike the securities laws where the States have State's secu-
rities laws and the securities laws exist at the Federal level, under
the Commodity Exchange Act, the CFTC is granted exclusive juris-
diction.
As a result of the prevalence of fraud, in 1928, there were some
amendments to the Commodities Exchange Act granting the States
some limited authority to take action but our ability to act is very
limited against — ^we can only act after the fact. We cannot take any
action to license people, to require substantive standards to be met
beforehand, and there are a number of people that we are still pre-
cluded from taking action against.
Mr. English. I guess the question that occurs to me, and again,
not being an attorney, I certainly don't profess to have any legal
expertise in this area, but given the fact that there is that exemp-
tive situation as far as the Commodities Exchange Act is con-
cerned, then the CFTC exempts a particular group of instruments
from the antifraud and antimanipulation provisions under the
Commodity Exchange Act.
Does that raise a legal question as to whether the States even
after that exemption, since it may come under the jurisdiction of
the Commodity Exchange Act, will they even have authority to act
against fraud that they may discover within their boundaries be-
cause of the exemption and because of the application of the Com-
modity Exchange Act?
Mr. Klein. Absolutely, Mr. Chairman, because to the extent that
the Commodity Exchange Act grants the States some limited au-
thority to enforce the Commodity Exchange Act, to the extent the
CFTC has granted an exemption and said that the Commodity Ex-
change Act does not apply, not only has the CFTC denied itself ju-
risdiction, they have precluded the States from using the Commod-
ity Exchange Act to go after some of these operations.
Mr. English. So that places us in a position where not only the
CFTC has exempted itself from any kind of action against fraud or
manipulation, they are also, in effect, exempting that kind of action
by the States themselves.
Mr. Klein. It is so pernicious because in essence the CFTC be-
comes the protector of these operations, both the legitimate ones
and the fraudulent ones.
Mr. English. Mr. Allard.
Mr. Allard. The States, and I am interested in following up a
little more on the chairman's checking out the State's role in this,
the States, under the securities act, for example, on energy con-
tracts, which is one of the controversies that have come up in here,
do the States have any ability under their State security exchange
acts to regulate at all, anything?
Mr. Klein. To the extent that the contracts could be construed
as securities, yes, the States could use their securities laws.
Mr. Allard. Most of those contracts fall under those securities?
Can they be construed that way?
117
Mr. Klein. Congressman, I have not seen the way the contracts
are structured. In my opinion, they probably would not because se-
curities laws require that you will be making an investment now,
relying on someone else to make a profit, to return that profit to
you in the fiiture.
Under the futures contract, it is generally fewer parties and they
are making the contract now and they are relying on each other.
Mr. Allard. Are you aware as to whether any of the energy
States, those that produce oil and gas, have made any special effort
in trjdng to regulate this area?
Mr. Klein. Congressman, they have made efforts. To the extent
that we find fraud in this area, and Texas has been particularly
active as has Oklahoma, to the extent they find fraud in this area,
they do everything they can to stop it and if they can somehow
stretch the securities laws to apply, they will.
Sometimes they will use the general and the common law fraud
statutes. They are dedicated people who do everything they can to
get money back for the victims and stop the frauds but the problem
frankly is the laws do not address it well, particularly when the
Federal law has granted exclusive jurisdiction over certain types of
contracts.
Mr. Allard. Currently does the CFTC or any Federal agency
have individuals in these States that are trying to enforce Federal
law or work with the States in enforcing these laws?
Mr. Klein. Congressman, the CFTC does have several regional
offices. However, to the extent that the CFTC has exempted these
transactions or these parties, then the CFTC's regional offices will
lack the authority to act, as well as having, I presume, instruction
from the home office to ignore them.
Mr. Allard. I see. Are there any other Federal regulations that
deal with this area that you are aware of?
Mr. Klein. Congressman, the only other one that I think would
apply would be the general mail fraud statutes which would be ad-
ministered by the postal inspectors as well as the FBI.
But I don't think that they are without work to do and it is dif-
ficult to use those statutes, although it was used successfully in, I
believe, in some Chicago pit investigations.
Mr. Allard. Thank you, Mr. Chairman.
I yield back the balance of my time.
Mr. English. Thank you very much.
Ms. McKinney.
Ms. McKinney. Thank you, Mr. Chairman.
I just have one question and I don't know if it is for you or if
it is for the chairman, but you make a recommendation in your tes-
timony that the action that we take be retroactive.
Let me see if I can find it, and I want to know, I don't see that
that is specifically stated in the legislation, is it?
Mr. English. No, it is not. There is not a provision for it to be —
excuse me — counsel is pointing out to me, they are required to go
back and amend their orders, but as far as retroactive action
against people who may be violating it, which I think you are refer-
ring to, any violations that have occurred since the order came out
from the CFTC, they wouldn't.
118
But of course they are still in the process of implementing that
order. So we are kind of in a twilight period here where both the
CFTC is implementing the order that they have come down to at
the same time that we may have it here.
Of course rules and regulations have to be promulgated to deal
with this law should it pass and be signed by the President.
Ms. McKlNNEY. So to some extent it is retroactive. Is that what
you are saying?
Mr. English. Well, it is retroactive as far as the action that we
are taking against what the CFTC has done in their ruling to ex-
empt antifraud and antimanipulation. If you would be interested in
offering an amendment along those lines, as has been rec-
ommended, that might be appropriate once we open the bill up for
amendment.
Ms. McKlNNEY. Is that what you would recommend?
Mr. Klein. Mr. Chairman, Congresswoman, yes.
Because we have already had 2 months where the exemption has
been in place and based on my experience, I can tell you that there
are many fraudulent operations out there that are quickly going to
the printers with new brochures and sales pitches and depending
how much time elapses before this amendment can pass both
Houses and be signed by the President. I think we need to close
that gap.
Ms. McKlNNEY. OK, Mr. Chairman, I would like to do that.
Mr. English. Thank you very much.
Mr. Smith.
Mr. Smith. Mr. Chairman, thank you.
I am just coming up to my learning curve on this, but I would
be curious whether your jurisdiction to protect against fraud
matches your technical and staff ability to do that or is there some-
what of a false impression that we are sending out that you are
really doing more than you are capable of doing?
Mr. Klein. That is always a risk that we — the Government sends
out when they say: Here are the things that we will do and we
have taken the responsibility to protect the markets against fraud.
And in a sense then, every time I bring an enforcement action,
I am admitting a certain type of failure because I have only been
able to act after the fact to put somebody in jail, to stop a fraud,
to get money back for the victims.
We can never do the kind of job that we wish we could.
Having said that, however, I think that there is a tremendous
amount of expertise and dedication at the State level in individual
States and the States acting together, and with that expertise and
those resources of combining efforts, the States have acted some-
times individually and sometimes jointly with the Commodities Fu-
tures Trading Commission to close down a number of large fraudu-
lent operations, many of them nationwide.
And as a result, I think the expertise and the resources are
there, never as much as we would like, but enough that we can go
after the worst crooks.
Mr. Smith. So, Mr. Chairman, as a follow-up, do I understand
you to say that, no, you don't think we are misleading anybody in
terms of your ability to protect against that fraud?
119
Mr. Klein. Congressman, I think that there is a real danger that
we are misleading the public about what the CFTC is doing to keep
the markets free of fraud. I think the implication, which you want
the public to have, if they go trade on regulated markets, it is going
to be safe and fair and free of fraud or manipulation.
I think that message is a false one, but I think that to the extent
the States see fraud and can find any way to act, they will.
Mr. Smith. Thank you, Mr. Chairman. That is all I have.
Mr. English. Mrs. Clayton.
Mrs. Clayton. Mr. Klein, the tone of your testimony is interest-
ing as well as your written work. I am interested to know a little
bit about the relationship between the States and the CFTC.
Has it deteriorated or was there ever an area when you felt they
weren't really performing their regulatory jurisdiction? Was there
a time when they understood what their oversight responsibility
was and had a good relationship protecting the public, or has some-
thing occurred within the recent period of time that we need to ad-
dress?
Mr. Klein. Congresswoman, I would like to first make a distinc-
tion between the policymakers on the Commission and the staff. In
the midlevel, staff members, the Directors of the various divisions
and their staff people have always gotten along very well with the
States.
But as far as the CFTC as an entity, it has been a roller coaster.
Prior to 1982 the CFTC was very intent on protecting its exclusive
jurisdiction, to the point that even in late 1979 or 1980, States had
brought some action against fraudulent operations and the CFTC
actually intervened in those lawsuits sa5dng the States had no au-
thority, and that led to Congress adopting the amendment in 1982
giving the States some limited authority, and things went very well
until about 1985 when the CFTC adopted an exemption or essen-
tially gave a no action position — opinion letter — for bank financed
precious metals which spawned a whole new generation of fi'audu-
lent operations where people would buy the metals. They put 20
percent down. The metal would then be transferred to some other
entity which would hold it, and the CFTC said that takes it out of
the futures contract, and that then spawned many frauds.
And then from there the branch statutory interpretation, the
CFTC's action in connection with a lawsuit in A-Mark that is men-
tioned in my testimony and now this exemption has strained rela-
tions very much with the policymakers of the Commission although
it remains fairly good with the senior staff.
Mrs. Clayton. Is there, in your judgment, philosophically, a
trend that we need to be conscious of that needs to be stopped? Ap-
parently this policy, if they have exclusive jurisdiction, is that their
interpretation or is that actual policy?
Mr. Klein. Exclusive jurisdiction provided visions are contained
in the Commodity Exchange Act and the statute grants them that
jurisdiction. Yes, I think there is a trend and I think it is a dan-
gerous trend.
I think it perhaps can still be reversed, but they are not listening
to the staff and unless things change soon, it is going to be too late
to go back.
120
Mrs. Clayton. Do you have recommendations about that beyond
your testimony?
Mr. Klein. Congresswoman, the recommendations we would
have are contained in my testimony and the attachments which are
included and letters that have been submitted to the CFTC and to
the President.
Mrs. Clayton. Thank you very much.
Thank you, Mr. Chairman.
Mr. English. Mr. Gunderson.
Mr. Gunderson. Thank you very much, Mr. Chairman.
Mr. Klein, I want to read to you a statement from Commissioner
Dial as a part of his testimony submitted to this subcommittee.
"As of this date, no one has put forth a plausible scenario where-
by the exempted energy contracts would subject the public interest
to a fraudulent scheme. Granted, there are those who ascribe to the
theory that this exemption will allow for general public participa-
tion through the use of pools, trusts, or partnerships and the CFTC
would not be able to use the 4(b) fraud provisions to prosecute
fraudulent activity in these circumstances. That is not the case."
Will you comment on that statement?
Mr. Klein. Congressman, I deeply wish he were correct — wish I
could agree with him. Unfortunately, I think that his own division
of enforcement disagrees based on the memo that I have seen that
they submitted to the chairman before this exemption was granted.
In addition, some discussions I have had with people familiar
with the CFTC, we have identified situations where it is possible
that people are going to pool their money, it will be invested by
someone else claiming to meet the minimum asset requirements
contained in this exemption and, yet, they are not truly going to
be the sophisticated investors that they appear to be.
And the ones who are going to lose money are going to be the
investors who participate in this pool and it is going to be an un-
registered commodity pool, or it will be a company whose stock-
holders are just investing, or it is going to be people who are going
to find some other way around it, and as we saw in A-Mark unfor-
tunately, the lawsuit that we brought as bankruptcy trustee, some
courts at least are willing to say that a small dealer who works out
of an old house and buys and sells used gold fillings and school
rings qualifies as a commercial entity, and I think it is a mistake
to say that those people are able to protect themselves against
multibillion dollar companies.
Mr. Gunderson. So you do not believe that the antifraud provi-
sions under 4(b) are adequate to prosecute?
Mr. Klein. Congressman, I do not.
Mr. Gunderson. OK.
Thank you, Mr. Chairman.
Mr. English. Thank you.
Ms. Long,
Ms. Long. I have no questions.
Mr. English. Well, thank you very much. I appreciate it, Mr.
Klein, your testimony has been most helpful.
Mr. Klein. Thank you, Mr. Chairman.
Mr. English. Our last witness this morning is Mr. Kenneth
Raisler, who is with the Energy Group from New York.
121
STATEMENT OF KENNETH M. RAISLER, ATTORNEY, ON
BEHALF OF THE ENERGY GROUP
Mr. Raisler. Thank you. Mr. Chairman, and members of the
subcommittee, my name is Kenneth Raisler. I am an attorney with
the law firm of Sullivan & Cromwell. I am appearing today on be-
half of nine energy companies, each involved in commercial busi-
ness relating to crude oil, natural gas or their products and by-
products.
I represented these energy companies in their application to the
CFTC for an exemption that was the subject of this committee's
earlier hearing and has been discussed today. I have submitted a
written statement for the record which sets forth in detail our posi-
tion on H.R. 2374.
In my oral statement, I wish to make only a few brief points.
First, as a personal matter, prior to joining Sullivan & Cromwell,
I served in the U.S. Department of Justice, including a tour as a
criminal prosecutor in the District of Columbia. I also served as the
General Counsel of the Commodity Futures Trading Commission.
In that capacity, one of my jobs was Chairman of the CFTC State
advisory committee and I am pleased to say from Mr. Klein's testi-
mony it was during the period of 1982 to 1985 when the roller
coaster, at least he indicates, was at high level.
From my personal perspective and the perspective of the group
I represent, I am adamantly opposed to fraud in any market, in-
cluding the market covered by the energy exemption. My view and
the view of the group that I represent is that the bill is not an ef-
fective way to address this issue.
Instead, it may create false impressions and confusion that may
deter important participation in these markets.
Congress in the 1992 Futures Trading Practices Act directed the
CFTC to address an exemption for forward contracts in order to re-
solve what was legal uncertainty that came about as a result of one
district court decision in New York.
Forward transactions, it is very important to realize, are and al-
ways have been excluded from all of the provisions of the Commod-
ity Exchange Act and CFTC jurisdiction, not just antifraud, but
they are outside the act in their entirety.
Transactions described in the exemptive order are generally rec-
ognized to be such forward contracts outside the CFTC's jurisdic-
tion. The exemptive order seeks to clarify this very point.
In our view, application of the CFTC's antifraud jurisdiction only
confuses the picture. The CFTC has never overseen or been in-
volved in policing these markets. I believe that is just a critically
important point. Without the staff or the expertise, retaining anti-
fraud jurisdiction could create a misleading impression about the
CFTC's abilities.
Moreover, CFTC authority is limited. The CFTC has to prove
that these contracts are, in fact, futures contracts and in fact they
are generally recognized instead to be forwards. Parenthetically, I
would point out that that debate opens up court actions on what
is a futures contract versus what is something that is not a futures
contract, which is the very point that this committee and the Con-
gress sought to avoid by giving the CFTC exemptive authority.
122
We are unaware of any evidence of fraud in these markets or any
of the markets covered by the exemptive order.
In fact, Mr. Klein made reference to fraudulent operators out
there and going to the printer. We are unaware and we would be
most interested in hearing about any such evidence. We are aware
of none and to our knowledge we are not aware of any that have
occurred in the past either.
If problems arise in these markets, it is our view that both the
participants and the authorities can seek recourse under applicable
State and common law. In fact, the CFTC and every authority that
I am aware of is on record that the goal, when there was fraud in-
volved, is to bring criminal prosecutions.
Criminal authority is free and available to the Federal Govern-
ment using mail and wire fraud statutes and they have repeatedly
used those in any kind of activity that involves fraud, as well as
the States using their various statutes to bring to bear.
It is important to recognize that the exemptive order does not
permit activities that could be the cause of public fraud. The gen-
eral public and individuals are not eligible for the exemption. Both
parties to the energy exemption contracts must be commercial par-
ticipants with substantial net worth or assets, at the $1 million
level for net worth and $5 million for assets.
Public marketing and sales, whether high pressure or not, are
not permitted. Thus, if such activity, and I believe the activity that
Mr. Klein described, were to occur, it is our strong belief that the
exemptive order would not apply in any way and the CFTC would
have available its full panoply of authority, not just its antifraud
authority.
The goal of legal certainty sought by the energy companies has
been achieved by the CFTC's exemptive order. Foreign counter-
parts, no longer confused about the applicability of the act and
CFTC jurisdiction, are prepared to enter into energy contracts in
the United States.
This result provides important benefits to the U.S. energy compa-
nies and energy consumers allowing greater certainty in the pricing
and sourcing of energy.
We endorse the goals of Congress in enacting the Futures Trad-
ing Practices Act which provides the CFTC with important discre-
tion. If an exemptive order like that issued for energy contracts is
determined to have unintended effects, the CFTC can always re-
visit it and tighten up its requirements or clarify its terms.
In our view, in fact, that is the better approach because the
CFTC antifraud authority on its own is insufficient. It would need,
if it finds activities to go outside, to go beyond antifraud and look
to other regulatory and other kinds of prohibitions and the way to
do that, in our opinion, is to modify the exemptive order if prob-
lems occur.
We see no reason for problems to occur because the exemptive
order is very carefully designed to avoid the public marketplace.
For these reasons, we do not endorse the automatic application
of the act's antifraud provisions. I appreciate the opportunity to ap-
pear before the committee and would be happy to answer any ques-
tions that the committee has.
Thank you, Mr. Chairman.
123
[The prepared statement of Mr. Raisler appears at the conclusion
of the hearing.]
Mr. English. Thank you very much, Mr. Raisler, I appreciate
that.
As was pointed out by Mr. Klein, I was particulariy struck by the
fact that this part;icular action, this exemption from fraud £ind ma-
nipulation, £iny type of fraud and manipulation application of the
Commodities Exchange Act, that that recommendation came from
the economic division over CFTC, while being opposed, strongly op-
posed, by the enforcement division.
Now, it may be fine from an ivory tower economic theory stand-
point to say, hey, we are opposed to all regulation. Let's deregulate,
and if that is where we are, then we might as well do away with
all our Government entities that have regulations as their respon-
sibility.
That is free trade, that is wide open, and I understand that
many in our country would like that, many who are ivory tower-
types. Then we have the other types. We have the fast buck boys
and the fast buck boys are always looking for an edge and if you
are going to open the door and say, the Federal Government is not
interested in whether you create fraud, involved in fraud or manip-
ulation of markets, I guarantee you they are going to be delighted
to step in and take advantage of that situation.
Now, I don't think that the people at the CFTC who voted for
this two to one, that was what the margin was of the Commis-
sioners, we have a lot of vacancies over there, don't we?
Mr. Raisler. That is correct.
Mr. English. Two to one. I don't believe those two who voted for
this actually want to open this market up for fraud and manipula-
tion. I believe that they listened to the ivory tower-types, but I
think it would be very naive, as I told them before, to expect that
is going to be the case.
I would also make the point that where you are talking about
being misunderstood, foreign counterparts might misunderstand, I
have never been able to understand why people overseas would feel
that it is somehow confusing that we are opposed to fraud and ma-
nipulation.
Most people, it seems to me, when they enter into a transaction,
like to feel like they are going to be dealt with fairly, not some fast
buck guy in there that is going to gouge him. And I can assure you,
whether they are domestic or foreign, if we are going to turn our
back as a Nation, those people are going to be present. They are
in our society.
It would be nice if it were not the case, but I have a very hard
time buying your argument that somehow these people are going
to feel that in some way it is burdensome to be protected from
fraud and from manipulation. That is an interesting argument, but
I simply don't think that exists.
Now, I have also heard from some, well, these are the big boys.
We shouldn't concern ourselves because these are the big boys.
Well, the big boys fall too, and when they fall, they fall on a lot
of little people. The little people get hurt when the big boys fall,
and the big boys are just as subject to manipulation and fraud as
anybody else, and perhaps we shouldn't concern ourselves when-
124
ever they get gouged or taken, but we have a lot of companies that
these big boys represent, and when those big boys go down, when
they go into banlaiiptcy, whenever they have problems, that rever-
berates throughout the economy and a lot of little people get hurt.
I think all the people of this country deserve to be protected from
fraud. They deserve to be protected from those who would manipu-
late, and quite frankly, I am astounded by the fact that you would
come here before us saying that, golly, we shouldn't extend our
laws dealing with fraud and manipulation to those who may come
under the jurisdiction of the CFTC, and as I am sure you are well
aware, this legislation of course applies only in those cases, to
those instruments, that are not covered under the jurisdiction of
some other regulator.
So I don't have any questions, but I have to say, I felt compelled
to make those points.
Mr. Allard.
Mr. Allard. From your perspective, do you feel that the anti-
fraud and the rules and regulations that we have in place now pre-
vent boilerroom operations, particularly in regard to the energy
contracts that had come up as an issue with the CFTC?
Mr. Raisler. I think there is very much a misimpression about
this CFTC exemption and who it applies to. In our strong view, any
boilerroom-type activity would not be eligible for this exemption. So
the issue of the application of antifraud is irrelevant. The legisla-
tion, therefore, is irrelevant.
Our view is if somebody, in the chairman's words, the fast buck
boys are out there selling this product to somebody, the CFTC ex-
emption does not apply, and I don't want to send a signal to any-
body out there that they should be able to take advantage of this
exemption under those means.
The fact is that it is very important, and I agree with the chair-
man's comments, that everyone in this country and throughout the
world deserves to be protected from fraud. The fact of the matter
is that the CFTC's application of antifraud jurisdiction under this
bill is a very narrow aspect and that the people who are out there
marketing boilerrooms should understand that they have no oppor-
tunity to get the benefits of the CFTC exemption, and if they try
to rely on the exemption, it should be clear from the CFTC, and
everybody else, that their business should be put to a halt, and
that that exemption does not apply and all CFTC jurisdiction can
be brought to bear to shut them down, and hopefully the States
and the Federal criminal authorities are also at hand.
Mr. Allard. In the early part of your testimony, you had begun
to draw some distinctions between forwards and how these energy
transactions may differ.
Is there a significant difference between forwards and the energy
contracts who have the exemption?
Mr. Raisler. No. In our view, not at all.
The fact of the matter is that this whole issue comes up because
a district court in New York found that some of these contracts
were, in fact, futures.
Our position is that decision was wrong. The CFTC issued a stat-
utory interpretation in effect saying that that decision was wrong.
The exemptive authority gives us a way to put a belt with those
125
suspenders, if you will, to make it clear to everybody out there that
this activity is forwards activity. In effect, this activity is outside
of CFTC jurisdiction.
That is the goal that we went to Congress and sought in the leg-
islative history to the Futures Trading Practices Act and that is the
goal we believe was achieved by the exemptive order. So I think
that is important to recognize, we are not talking about deregula-
tion in this market.
That it is a forwards market; that the CFTC, since the Commod-
ity Exchange Act was adopted in 1922, has never had jurisdiction
over the buying and selling of goods which, in effect, is what this
energy exemption seeks to clarify and affirm.
Mr. Allard. In your view then, does the CFTC have the re-
sources and the expertise to regulate the energy exemptions if we
bring them back in under the fraud?
Mr. Raisler. Our opinion is no. The fact is the CFTC has never
regulated or overseen or policed the forward markets. The CFTC's
resources are limited, as this committee well knows.
The CFTC does not have any individuals stationed in any of the
States that are energy producing or energy trading States. There
are no CFTC employees in Texas, Oklahoma, or Louisiana, for ex-
ample. To expect the CFTC, and this is where we are concerned
about a misleading impression to the marketplace, to expect the
CFTC to be policing fraud wherever it occurs in the country I be-
lieve gives the public a misleading impression about that level of
protection. If it is determined that protection is needed, a more
radical step than giving CFTC antifraud jurisdiction should be the
way to solve the problem.
We don't believe that is necessary because the exemption is nar-
rowly drawn to a marketplace that has never been regulated by
any Federal regulator, including the CFTC.
Mr. Allard. What has been your experience in dealing with the
States? We had a previous witness who gave the State's perspective
on the rules and regulations.
And now representing those who are regulated or could be regu-
lated, what is your perspective on the State's role in this area as
far as regulation is concerned?
Mr. Raisler. I think it is important to recognize that the States
do have an important role to play. The CFTC, in fact, if I can go
back a bit in time, in 1982, which is when Mr. Klein talks about
the environment changing at the CFTC and there was a better re-
lationship with the States.
In 1982 this committee recommended and Congress adopted a
change to the Commodity Exchange Act. Up until that time the
CFTC was exercising exclusive jurisdiction over not just the mar-
kets in which — the futures markets, the exchange traded futures
markets, but also the cash markets and where commodity advice
is being given.
The CFTC recommended, and this committee endorsed, taking
away that authority from the CFTC and giving the States very
broad authority to develop their own laws. In fact, the States have
moved forward with a model State commodity code to prohibit the
boilerroom and bucketshop activity at the State level.
72-584 0-93-5
126
This has been a very important initiative adopted by a number
of States and strongly supported by the CFTC and I beheve the
pubHc at large. The States have an important responsibility. They
have worked closely with the CFTC over a number of years. It is
important to recognize as these markets evolve that the States con-
tinue to have a responsibility and that responsibility particularly
is focused on the fraud level, particularly focused on the boilerroom
level at the local — in the local areas.
Mr. Allard. Madam Chairman, I tried to clear up in my mind
sort of a chronology here
Ms. Long [assumed chair]. Without objection.
Mr. Allard. So we had a period of time there where there prob-
ably wasn't much thought or concern about commodities or the fu-
tures and swaps and those sort of gray contracts, that gray area,
and then was there a period of time when we had the CFTC explic-
itly prohibit the States, where they actually exempted the States
and then went back into a period of time after that where then the
States then were allowed this regulatory authority and they are in
the process now of passing the CFTC acts that you referred to in
your comments?
Mr. Raisler. Right. If I can—prior to 1982, the CFTC effectively
preempted the States from dealing with off exchange trading, that
is, the trading that existed away from the futures markets. That
changed in 1982.
The States now have very broad authority and they have author-
ity to adopt, at the State level, their own laws. There is the model
State commodity code which each State is free to adopt and a sig-
nificant number of States have adopted a form of model code.
The intent of that model code is to prohibit commodity-related
fraud at the State level and the CFTC has worked with the States
to do that since 1982. In the last decade, enormous progress has
been made and a lot more vigilance has been paid to the boilerroom
activity.
Let me just point out that from our point of view, the whole dis-
cussion of fraud in the boilerroom context really does not apply to
this energy exemption which we believe would not be available to
a boilerroom-type purveyor, but my answer to your question stands
with that caveat at the end.
Mr. Allard. Thank you, Mr. Chairman.
I see my time has run out.
Mr. English [resuming chair]. Ms. McKinney.
Ms. McKinney. No questions, Mr. Chairman.
Mr. English. Mr. Penny.
Mr. Penny. No.
Mr. English. Ms. Long.
Ms. Long. You have partially answered this, but I would simply
say that if you think there is no fraud or abuse, then if you would
just say specifically why you oppose the bill.
Mr. Raisler. I think there are several reasons. The first is that
by enacting this bill and giving the CFTC this antifraud authority,
you are creating, I believe, the impression in the marketplace, one,
that a variety of activities that we believe are not covered by the
exemption may be permitted under the exemption and the CFTC
should therefore use its antifraud authority to stop them.
127
Two, you are creating the impression that the CFTC will be able
to stop fraud in these markets if such fraud were to occur when,
in fact, the activity is basically outside the exemptive order. Both
the States and the CFTC are able to proceed to stop that fraud now
with the exemptive order in place and there is no reason to impose
that.
The last point is that bringing antifraud into the exemptive order
creates confusion as to what is the CFTC's jurisdiction in this area.
We have sought by the legislation in 1992 and the exemptive order,
to clarify in essence that these are forward contract-like instru-
ments which the CFTC has never had any jurisdiction over.
We believe that is the right result and that is the result that is
indicated by a pattern of activity, including an earlier statutory in-
terpretation of the CFTC. Bringing antifraud in basically says, in
effect, these things are futures-like and forces the CFTC, if it
wants to proceed with a fraud case, to prove that contracts which
we have tried to present to be forwards and not under CFTC's ju-
risdiction are finding their way into the CFTC's jurisdiction again
as futures, and that debate is one we thought we had avoided with
the exemptive authority and with the 1992 legislation.
Ms. Long. Thank you.
I don't have any other questions, Mr. Chairman.
Mr. English. Thank you very much.
Mr. Smith.
Mr. Smith. Help me understand what kinds of fraud might be an
example of — that would take place that the lesser ability of the
CFTC couldn't determine.
Help me understand what kind of fraud might happen.
Mr. Raisler. I think that if I understand your question and if
I don't, please redirect this to me.
Mr. Smith. I don't have an understanding what kind of fraud
might happen in this energy contract.
Mr, Raisler. There are really two kinds of frauds that people are
talking about today as I hear it. One is the sort of purveying to the
general public — this sort of boilerroom-type activity that has gone
on in precious metals historically where people are getting on the
phone and hawking a product. People are sending out literature
saying, gold is going through the roof or whatever, and that kind
of activity is not covered by this energy exemption at all.
So in our view, the CFTC has full authority to stop that kind of
boilerroom activity, as do the States under their various State stat-
utes.
The other kind of fraud
Mr. Smith. Excuse me. Would there be more penalties, if you
didn't have the exemption and it was discovered, would there be
more penalties than just the prosecution under State statutes?
Mr. Raisler. No. I would say it is apples and oranges. The
exemption has nothing to do with that boilerroom business. That
boilerroom business cannot rely on the energy exemption so there-
fore that boilerroom business is thrown back into all of the provi-
sions that make their conduct illegal.
So there is no — the current energy exemption really has nothing
to do with the boilerroom business.
128
Mr. Smith. But it has to do with some business. It might not oth-
erwise be covered under the State statutes.
Mr. Raisler. The kind of fraud one thinks about — the energy ex-
emption appHes to when two over-the-counter parties, both com-
mercial entities who are in the energy business, deal with each
other, and it is certainly possible that in those dealings one could
defraud the other — one could make — I mean, it is — one could not
pay on its contract, one could misrepresent its assets, one could
misrepresent that they had the oil when they hadn't yet bought it.
Those are the kinds of disputes between two commercial parties
that historically have, if they have existed and generally in this
market we are not aware of them, but if they had existed, would
be the subject of litigation between those two commercial
counterparties where they could rely on a whole variety of common
law and State fraud statutes as well as contract statutes and other
legal remedies.
Mr. Smith. Mr. Chairman, I don't want to take any more of the
subcommittee's time.
I will pursue this, my questions directly, but my experience is
that the less our ability to determine that fraud and criminal activ-
ity, sometimes the greater the penalty helps to act as a deterrent.
Mr. English. Will the gentleman yield?
Mr. Smith. Yes, sir.
Mr. English. One statement you made I am having a great deal
of trouble understanding, Mr. Raisler, how in the world, with re-
gard to any kind of action taken, if CFTC has exempted itself, that
is what is happening. They are totally exempt. They can't take ac-
tion under any circumstances?
Mr. Raisler. Just one quick point on that, Mr. Chairman, just
to clarify. The CFTC has
Mr. English. Isn't that correct?
Mr. Raisler. Just one specific point. The CFTC is
Mr. English, All I am asking is it true or not?
Mr. Raisler. With one exemption. The CFTC has retained
antimanipulation authority.
Mr. English. That was another question I was going to ask you.
Since they have retained that antimanipulation authority, and I
believe you said in response that they don't have the capability to
deal with any kind of antimanipulation or any manipulation that
may take place, but they have the authority on price manipulation,
don't they?
How can you, in fact, have the capability to carry out the respon-
sibilities on price manipulation, in fact, how can you have any ju-
risdiction if you have the capability of taking action on price ma-
nipulation, but you don't have it in any other area of manipulation?
Mr. Raisler. I believe the CFTC has full authority in the manip-
ulation area.
My comment was directed to the fraud area. Manipulation is
when you manipulate the price in the marketplace and the CFTC,
through the futures markets in particular, has always been con-
cerned about that.
Mr. English. You said that they don't have jurisdiction. This is
a forward contract. CFTC has no jurisdiction, therefore, CFTC can't
get involved, can they? You either got it or you don't have it.
129
Mr. Raisler. CFTC always has jurisdiction over price manipula-
tion.
Mr. English. No matter whether it is a futures contract or not?
Mr. Raisler. That is correct.
Mr. English. That is not a futures contract, if it is something
CFTC has no jurisdiction over, they in no way can take any kind
of regulatory action against a security. That comes under the SEC.
You can't take it against any other kind of instrument. The only
jurisdiction they have is on a futures contract and the problem
came about in this area because you had a court determine that
these were futures contracts.
Mr. Raisler. Mr. Chairman, on the issue specifically of manipu-
lation, the CFTC has always had authority over the cash markets.
Specifically in connection with the attempted manipulation of the
silver market in 1980 by the Hunt family, the CFTC did
proceed
Mr. English. Those were on market, on exchange transactions,
Mr. Raisler. The CFTC's proceeding was a manipulation of both
the futures market and the cash market and its enforcement au-
thority affected both the futures market and the cash market.
Mr. English. The only authority they have is if that is deter-
mined to be a futures contract and the way that the CFTC is deter-
mining if it is a futures contract today is if it is traded on an ex-
change.
If it is not traded on an exchange, I don't believe you can name
me a single instrument that is being traded off exchange that the
CFTC has been making the determination they havie any kind of
authority over it, doesn't matter what the court says.
Mr. Raisler. CFTC continues to bring proceedings on off ex-
change futures trading, including in the foreign exchange market.
Mr. English. Name one.
Mr. Raisler, There are two cases pending in the eastern district
of New York involving foreign exchange trading.
Mr. English. None of those contracts are being traded on ex-
changes at all?
Mr. Raisler. That is correct,
Mr, English, Any exchange in this country, absolutely none?
Mr. Raisler. If I understand the chairman's point, the people
who sold those contracts were not trading them on an exchange.
Mr. English. That isn't the point. The question is, are those in-
struments being traded on an exchange?
Mr. Raisler. If I understand the chairman's question
Mr. English. You understood my question. Is it being traded on
an exchange or is it not?
Mr. Raisler. It is not.
Mr. English. Absolutely. Nowhere in this coimtry on any ex-
change that is regulated by the CFTC are any of those instruments
being traded in any form?
Mr. Raisler. The answer to that question is certainly yes.
Mr. English. All right. That is my point. That is where the tie
comes in.
If these contracts are not being traded on exchanges, the CFTC,
from a practical standpoint, has made the determination those are
not futures contracts and they have no jurisdiction. If they are fa-
130
tures contracts, they are required to be traded on exchanges, aren't
they?
Mr. Raisler. Not pursuant to various exemptions the CFTC has
granted and not pursuant to the
Mr. English. I will come back. CFTC has made under the law,
under the Commodity Exchange Act, if an instrument is deter-
mined to be a futures contract, the CFTC says it has to be traded
on exchanges. In fact, the law says it has to be traded on ex-
changes; isn't that correct?
Mr. Raisler. I agree that is what the law says, yes.
Mr. English. All right. I know that you may not like the law,
but that is what the law says.
Mr. Raisler. But the CFTC is granted a variety of exemptions,
including the recent swaps.
Mr. English. That is exactly why we are here today. They have
granted a variety of exemptions and that is exactly the problem.
The CFTC is whiddling away at the law.
In this case we have gone to the point where in fact they are
willing to exempt fraud and manipulation. The question that is
going to come down to and going to be determined by this Congress
and by this legislation is whether or not this Congress is going to
endorse that or not.
We have carried the issue of deregulation to the point that a reg-
ulatory agency says we are going to turn a blind eye to fraud and
manipulation, even if it is in our jurisdiction, even, in fact, in light
of the fact that this Congress, through its reauthorization, stated,
we are going to determine whether off exchanged instruments are
being traded, what they are and who they will be regulated by.
We want status quo. Whenever you start exempting on the basis
of fraud £md manipulation, that is not status quo, and that is what
brings us here today.
Mr. Nussle.
Mr. Nussle. Thank you, Mr. Chairman, and just to make sure
I understand the remedy that you are prescribing in the alter-
native of passing this particular piece of legislation is the civil
courts?
Mr. Raisler. Two basic remedies is that the parties of course
have — and the authorities have the criminal courts as well as the
civil courts available, but to the extent that this exemption is found
to raise the possibility of abuse in some area, the CFTC, because
it is only an exemption, the CFTC can revisit it.
And our position is that as the major players in these markets,
we don't want fraud in these markets. We have no interest in pro-
moting fraud in these markets and if there is a problem and we
don't believe the way this is designed there will be, but if there is
a problem, we will be the first to recommend the CFTC revise the
exemption to clarify that certain participants should not be eligible
for it, and that is in addition a very significant remedy that is
available to the CFTC and to the public at large.
Mr. Nussle. But having this in effect, doesn't that provide some
deterrent effect? You are talking about closing the bam door after
the horses are out.
I am saying, is there a deterrent effect of having this kind of leg-
islation on the books?
131
Mr. Raisler. The concern that we have is that there may be
more confusion than deterrent by putting this on the books.
Mr. NUSSLE. Sometimes confusion is a deterrent.
Mr. Raisler. Well, the question though is whether that may
deter legitimate players from participating in the market because
they are concerned about the scope of the CFTC's jurisdiction in an
area which is basically deemed to be forwards outside of CFTC ju-
risdiction.
That is the concern in terms of confusion.
Mr. NusSLE. OK, but the bottom line though is that the real
remedy that you are prescribing in the alternative of this legisla-
tion is the civil courts.
You are basically saying let the buyers beware, let the market
beware, and you are on your own, you take care of it on your own.
You have to investigate it, you have to uncover it, you have to be
aware of it, and then you have to prosecute it.
Mr. Raisler. And let me point out, as a general matter in this
country the buying and selling of goods, whether they be energy or
any other kind of product, find themselves with that remedy, yes.
Mr. NusSLE. Usually on a lot less sophisticated scale. Bujdng a
candy bar at a local convenience store is not the same as purchas-
ing securities, forwards, futures, or whatever it might be.
Mr. Raisler. We are not talking here about investment con-
tracts. What we are talking here about is the buying and selling
of cargoes of crude oil and pipeline delivery of natural gas, between
the kind of people that are represented in the Energy Group.
These are commercial contracts to move physical product across
State lines for purposes of getting that oil to the powerplant or to
the corporation that needs it.
These are not candy bar purchases, these are not retail pur-
chases, and these are not investment purchases. These are people
who are trying to buy and sell crude oil, natural gas, and their
products for their businesses.
Mr. NusSLE. And the Government has no place regulating or
monitoring that particular transaction, in your opinion?
Mr. Raisler. The Government never has, and so we see no rea-
son for them to start now.
Mr. NussLE. Well, if the Government never has, why would they
have granted an exemption?
Mr. Raisler. The district court in the southern district of New
York reached a conclusion which the CFTC disagreed with but was
nonetheless on the books, creating confusion about whether some
of those contracts might be futures imder the CFTC's jurisdiction.
Our goal here was to clean that up. The CFTC statutory inter-
pretation did that in part. This exemption was intending to make
the rest of that clear, and that is the full extent of what we were
trying to achieve here, no more.
Mr. NusSLE. Thank you, Mr. Chairman.
Mr. English. Thank you very much, Mr. Nussle.
I would like to say, Mr. Raisler, before you leave, I think the im-
pression is that since you are representing the Energy Group, that
this is a few big oil companies that are involved in all this trading
around back and forth, and those are the guys that are involved.
132
It is also my understanding the people who are involved in these
kinds of contracts, the people who would be subject to any fraud
or manipulation that may take place, also include municipalities
that operate power facilities, rural electric cooperatives and other
power suppliers, fleet operators, barge companies, railroads, air-
lines.
Wouldn't take but just a little manipulation, a little fraud to
push some of these airlines in bankruptcy and goodness knows
what impact that would have on our economy, other transport com-
panies, fertilizer producers, blasting producers, aluminum, steel
producers, and other energy dependent manufacturers, farmer sup-
ply cooperatives, and home heating associations, just to name a
few.
Mr. Raisler. That is certainly correct, Mr. Chairman.
Mr. English. And I don't hear any of them coming up here and
sajdng, golly, gee, throw me in that briar patch with all that fraud
and manipulation. We sure want to be manipulated.
We sure want a little fraud, so be sure and don't pass any bill
that is going to prevent us from being involved in all this fraud and
manipulation here.
Mr. Raisler. Mr. Chairman, the CFTC did put this exemptive
order out for public comment. It got 16 comments back and no-
body — and the CFTC specifically raised the antifraud issue. Nobody
argued then.
The State securities people did not come in, weigh in on the
issue, nobody put forward on that record a request that the CFTC
apply antifraud and in fact the vast bulk of the comments are spe-
cifically recommended against it.
So there has been an opportunity for people to weigh in on this
specific point and the CFTC teed it up and nobody was prepared
to hit it.
Mr. English. Would you please name the members of the Energy
Group so that we all know specifically who it is that is up here tes-
tifying in favor of fraud and abuse, manipulation?
Mr. Raisler. Mr. Chairman, I would be happy to name the mem-
bers of the Energy Group. We should be making it clear that we
are not testifying in any way in favor of fraud or any other
Mr. English. I am happy to hear that. So you have no problem
with the objective of the legislation?
Mr. Raisler. We have no problem with deterring fraud in any
market.
Mr. English. I am happy to hear that.
Mr. Raisler. If you wish, our written testimony includes the
names of the companies and I will read them. This is only in alpha-
betical order, so I am not
Mr. English. You are not slighting anyone.
Mr. Raisler. That is correct. BP Oil Company, Coastal Corpora-
tion, Conoco Inc., Enron Gas Services Corporation, J. Aron & Com-
pany, Koch Industries Inc., Mobil Sales and Supply Corporation,
Phibro Energy Division of Solomon, Inc., Phillips Petroleum Com-
pany.
Those are the nine companies who comprise the Energy Group
who submitted the application to the CFTC for the energy exemp-
tion and on whose behalf I am testifying today.
133
Mr. English. I appreciate that very much.
Thank you very much, Mr. Raisler.
Mr. Raisler. Thank you, Mr. Chairman.
Thank you.
Mr. English. That concludes our witnesses today.
[Whereupon, at 11:45 a.m., the subcommittee proceeded to other
business.]
[Material submitted for inclusion in the record follows:]
134
WRITTEN SUBMISSION OF PATRICK H. ARBOR,
CHAIRMAN,
BOARD OF TRADE OF THE CITY OF CHICAGO
ON H.R. 2374
Mr. Chairman and members of the Subcommittee, I am Patrick H. Arbor,
Chairman of the Chicago Board of Trade. Thank you for your invitation to present the
views of the Board of Trade on H.R. 2374 and the actions taken by the Commodity
Futures Trading Commission under its new statutory exemptive authority.
Su pport for H.R. 2374
The Chicago Board of Trade generally supports H.R. 2374. That
legislation would confirm that any person or transaction the CFTC exempts under
Section 4(c) of the Commodity Exchange Act must remain subject to fraud and
manipulation prohibitions.
The Board of Trade and other exchanges addressed this issue in their
December 1992 comment letter on the CFTC's proposed swaps exemption. The
exchanges urged the CFTC to exempt only those transactions that would be subject
to "core protections" under the CEA, including antifraud and antimanipulation. The
exchanges specifically stated:
"No one can legitimately claim that swaps that
are futures should be excused from the CEA's
antifraud and antimanipulation provisions.
Those protections are central to the customer
protection and market integrity purposes
underlying the CEA."
The Board of Trade also incorporated those comments in its comment letter on the
CFTC's energy contract exemption.
Unfortunately, in differing degrees, both the CFTC's swaps and energy
contract exemptions deviate from that policy. Under the swaps exemption, anyone
manipulating the price of an exempt swap would not violate the CEA unless that
135
manipulation effected a ripple manipulation on a futures exchange or in the cash
market as a whole. The swaps exemption also may be illusory or at least
cumbersome when it comes to fraud. Any fraud action would require the complaining
party to prove first that the swap is a futures contract and second that fraud occurred.
Other than shielding wrongdoing, no reason exists to make the complaining party
make a double showing.
The energy contract exemption has the same flaw in the manipulation
area as the swaps exemption and contains no antifraud protections. H.R. 2374 would
remedy the fraud omission somewhat by adopting a policy akin to the swaps
exemption, but might be interpreted not to prohibit manipulating the price of exempt
instruments. The attached revised version of H.R. 2374 attempts to address those
technical issues in H.R. 2374. The revised version also would preserve the rights of
any parties injured by fraud or manipulation in connection with exempt instruments to
bring private damage actions.
As an alternative to H.R. 2374, the CFTC could adopt a regulation that
prohibits fraud and manipulation in connection with any transaction that is otherwise
generally exempt from the CEA. The Board of Trade also would support that direct
approach to maintaining the core protections in the CEA.
Other Core CEA Protections - Clearing
Neither the CFTC exemptions adopted to date nor the provisions of H.R.
2374 address another apparent oversight in the exemptive area -- the role of clearing.
Clearing is the process for matching trades and removing credit risk for the parties to
a trade (the risk that a losing party to a trade will not pay the winning party).
-2-
136
Clearing is another core protection of the CEA, as the CFTC recognized
at its inception. In 1976, the CFTC proclaimed that unless a proposed new futures
contract was subject to an acceptable clearing system, that new contract would be
found to be "contrary to the public interest" and therefore unlawful. CEA §5(8). The
CFTC even has described clearing to be the "essence of the integrity of a futures
contract." 41 Fed. Reg. 40093 (1976).
Although the Commission historically had found the absence of clearing
to be " contrary to the public interest," in the recent swaps and energy contract
exemptions, the CFTC found the absence of clearing to be " consistent with the public
interest" for those exempt transactions. Perhaps la>yvyers can perceive a logical thread
in those policy judgments but I must say, as a businessman, I find that kind of agency
inconsistency to be difficult to fathom.
Compounding the puzzling nature of the CFTC's policy toward clearing,
both the Federal Reserve Board and the Securities and Exchange Commission
supported expanding the CFTC's exemption in the hope that clearing systems for
exempt derivative instruments would strengthen financial protections for those
instruments. Yet the CFTC refused to allow clearing for exempt instruments, a
process the Commission previously had viewed to be mandated by the public interest.
In recent weeks, many articles have appeared bemoaning the extent of
credit risk OTC derivative instruments now face. One guest editorial in the Wall Street
Journal even suggested that we, the taxpayers, are now underwriting that risk since, in
the absence of clearing, the U.S. government acts as the guarantor for all off-
exchange derivative instruments for U.S. financial institutions. Allowing clearing of
-3-
137
exempt instruments would strengthen the existing OTC markets and remove the cloud
of financial exposure now facing the taxpayers. For these reasons, this Subcommittee
should direct the CFTC to remove the ban on clearing of exempt instruments.
Fair Competition
As you know quite well, Mr. Chairman, Congress recognized in 1992 that
exchange markets compete with OTC dealer markets. Competition of this kind is
healthy, as long as it is fair. Congress therefore required the CFTC to promote "fair
competition" between OTC and exchange markets in exercising its exemptive powers.
The 1 992 Conference Committee specifically directed the agency to apply its
exemptive powers in a "fair and even-handed manner to products and systems
sponsored by exchanges and non-exchanges alike." The CFTC's exemptive actions,
thus far, have violated that directive.
Twice the exchanges have asked the CFTC to level the exemptive
playing field and allow exchange and OTC markets to participate in class exemptions
on a "fair and even-handed" basis. Twice the CFTC has rejected those requests by
precluding exchanges from offering exempt instruments.
The CFTC's policy is both inconsistent with the agency's 1 992 mandate
and unwise. Exchange trading would offer all market users the benefits of price
transparency, market liquidity and clearing. By affording market users more exempt
instruments to choose from, the CFTC would enhance competition for, and reduce the
cost to market users of, risk management services that are essential to all businesses
in our economy.
138
In 1 992, Congress understood the benefits of, and mandated the CFTC
to promote, fair competition. The CFTC's exemptive actions have ignored those
congressional findings. In any legislation you adopt, this Subcommittee and Congress
should reinforce the CFTC's fair competition mandate in a manner the agency can not
ignore.
Professional Trading Market Exemption
Since Congress granted the CFTC exemptive powers, the Board of
Trade has studied carefully the exemptions the agency has granted, the rationale for
those exemptions and the proposed exemptions submitted by others. Based on that
review, the Board of Trade has decided to file with the CFTC an exemptive request for
what we call a "Professional Trading Market." Under this proposed exemption,
exchanges would be able to offer those sophisticated and well-capitalized institutions
that use the OTC markets the benefits of transparent pricing (through floor or
electronic trading), legal certainty, and reduced credit risk, all at low regulatory cost.
Thus, the proposed exemption would promote responsible innovation by exchanges
and other boards of trade while promoting fair competition between exchanges and
OTC markets -- the very purposes Congress cited when it enacted Section 4(c) of the
Act.
Subject to certain conditions, a Professional Trading Market woulct be
exempt generally from CFTC regulation. Those conditions would be
1) only professional traders (no small, retail
public customers) could trade on this market;
-5-
139
2) the board of trade operating the market
would have to notify the CFTC when the
market begins operations;
3) all market participants would be subject to
special fraud and manipulation prohibitions as
well as private damage actions; and
4) all trades must be submitted to a CFTC-
approved clearing system.
The proposed "Professional Trading Market" exemption is "consistent
with the public interest" as required under Section 4(c) of the Act. In applying that
standard, the CFTC twice has found that any regulatory "concerns regarding financial
integrity and customer protection" are "addressed . . . through the requirement that
[exempt transactions] may only be entered into or transacted on behalf of large
institutions and other professional traders. The proposed exemptions would meet the
public interest test in exactly the stame way.
In fact, the proposed "Professional Trading Market" exemption has
considerably stronger regulatory safeguards than the exemptions the CFTC has
approved to date. In particular, the notification, private right of action and clearing
conditions of the proposal make it tighter from every regulatory perspective than other
exemptions the CFTC has adopted. The Board of Trade therefore will ask the CFTC
to approve this proposed exemption expeditiously.
Conclusion
Mr. Chairman, like you and the members of this Subcommittee, the
Board of Trade wants both the exchange and OTC markets to prosper. One noted
industry expert has observed that in today's financial world, exchange and OTC
140
markets both compete with and complement each other. The Board of Trade
therefore has a strong interest in seeing OTC markets thrive in a secure environment
so long as the competition between exchanges and OTC markets is fair and open.
The policies I have outlined today would serve to make that objective a reality. The
Board of Trade looks fonward to working with this Subcommittee under your
leadership toward implementing those policies.
141
[REVISED]
H.R. 2374 -- To amend the Commodity Exchange Act to ensure the continued
application of the Act's antifraud and antimanipulation provisions.
1 The Commodity Exchange Act (7 U.S.C. 1 , et seq) is amended by
2 adding to Section 4 the following section (e):
3 (1) It shall be unlawful for any person, directly or indirectly, in or in connection
4 with any agreement, contract or transaction that is exempt from Section 4(a) of
5 the Act pursuant to an exemption adopted by the Commission under
6 Section 4(c) of the Act or is exempt from any Commission-imposed contract
7 market designation requirement for options, or any similar requirement,
8 pursuant to an exemption adopted by the Commission under Section 4c of the
9 Act-
io (A) To cheat or defraud or attempt to cheat or defraud any
11 other person;
12 (B) To make or cause to be made to any other person any
13 false report or statement thereof or cause to be entered for
14 any person any false record thereof; or
15 (C) To deceive or attempt to deceive any other person by
1 6 any means whatsoever.
17 (2) In or in connection with any agreement, contract or transaction that is
18 exempt from Section 4(a) of the Act pursuant to an exemption adopted by the
19 Commission under Section 4(c) of the Act or is exempt from any Commission-
-8
142
1 imposed contract market designation requirement for options, or any similar
2 requirement, pursuant to an exemption adopted by the Commission under
3 Section 4c of the Act, it shall be unlawful for any person to manipulate or
4 attempt to manipulate the price of
5 (A) any such agreement, contract or transaction or
6 (B) any commodity in interstate commerce or any contract of sale of a
7 commodity for future delivery traded on or subject to the rules of any
8 contract market.
9 (3) Any person violating subsections (1) or (2) of this Section shall be
10 disqualified from relying upon any exemption granted by the Commission under
1 1 Section 4(c) or Section 4c of the Act.
12 (4) in accordance with the procedures set forth in Section 22 of the Act, any
13 person injured by a violation of subsections (1) or (2) of this Section may bring
14 a right of action for actual damages suffered as a result of that violation against
15 any person who committed or aided and abetted that violation. This right of
1 6 action shall be the exclusive remedy available under the Act to any person
17 injured by a violation of subsections (1) or (2) of this Section.
18 (5) The proscriptions in subsection (1) of this Section shall not apply to an
19 exemption for any agreement, contract, transaction, or person (or class thereof)
20 to the extent that such agreement, contract, transaction, or person (or class
21 thereof) is or will be subject to federal securities or banking laws that provide
22 comparable antifraud protection, as determined by the Commission."
143
^ ^,^ NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION. INC.
^^^^Mfl One Massachusells Avenue. N.V\ .. Suite 310
WKf Washington. DC. 20001
^t^ 202/737.0900
Telecopier: 202/783-3571
NASAA .
STATEMENT OF WAYNE KLEIN
Securities Bureau Chief
State of Idaho
on behalf of the
NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION
before the
SUBCOMMITTEE ON ENVIRONMENT, CREDIT,
AND RURAL DEVELOPMENT
Committee on Agriculture
U.S. House of Representatives
'H.R. 2374, regarding the application of the Commodity
Exchange Act's anti-fraud and anti-manipulation protections'
June 30, 1993
Preiideni: B«rr> C. Gulhar> <Massachu«eiis) • Presidcnl Eleci: Craig A. Goriisch (Iowa) • Secretary: \Ve&ley L. Ringo (Wisconsin) • Treasurer: Wayntr Klein (Idaho)
Directors: Le»ls W. Brothers. Jr (\irRinia1 • Philip A Feigln (Colorado) • Marcel del la Gorgendiere (SaskatcheHan) • Mark J. Grirfin (Nevada)
Richard D. Lalham (Tckas) • Executive Director: FoMler C. Mcsi
144
Mr. Chairman and Members of the Subcommittee:
My name is R. Wayne Klein. I am Chief of the Idaho Securities Bureau and a member
of the board of directors of the North American Securities Administrators Association
(NASAA). In the U.S., NASAA is the national voice of the 50 state securities agencies
responsible for investor protection and the efficient functioning of the capital markets at
the grassroots level. NASAA and its members work closely with the Commodity Futures
Trading Commission (CFTC) and National Futures Association (NFA) in combatting
commodity-related fraud. On behalf of NASAA, I appreciate the opportunity to appear
before you today.
INTRODUCTION AND OVERVIEW
NASAA is pleased to lend its strong support for the immediate adoption of H.R. 2374,
legislation which would amend the Commodity Exchange Act (CEA) to ensure the
continued application of the Act's anti-fraud and anti-manipulation protections, even in
those instances where exemptions from regulatory oversight otherwise are granted.
NASAA shares the serious concerns, and frankly, the frustrations that have been
expressed with respect to the CFTC's recent order exempting certain energy contracts
from most of the provisions of the Commodity Exchange Act, especially the Act's anti-
fraud and anti-manipulation provisions.
In addition to expressing support for immediate attention to the issue before the
Subcommittee today, I also would like to take this opportunity to discuss what we believe
is a more general (and disturbing) trend at the CFTC - that is, increasingly inadequate
and lax oversight of the commodities markets.^ In fact, the CFTC's order with respect to
exempting certain energy contracts is just the latest example of what perhaps may be
best characterized as the agency's "reluctance to regulate," even in the face of blatant
threats to investors and the integrity of the markets. Worse yet, the Commission has
vigorously guarded what it believes to be its "turf," only to turn around and severely limit
its own regulatory role. This minimalist approach seems to be one of "we won't police
the area but we don't want anyone else to either." It is our hope that such an approach
will not persist, and that instead, the Congress and the Clinton Administration will use their
considerable authority to re-direct the agency's effort with a clear sense of its original
mission and purpose.
I
The Association wishes to make a clear distinction between its concerns about the philosophy and
actions of Commission leadership in recent years and the Commission's hard-working staff, which deserves
credit for Its investor protection efforts.
1
145
OVERSIGHT OF THE FUTURES MARKETS
The futures markets today are recognized at home and abroad as a vital part of the
financial services industry. They provide the critical functions in our economy of risk
shifting, liquidity for commodity producers, and price discovery. The regulatory
environment in which the futures markets operate should recognize and compensate for
the features unique to them, including: (1) participation by a relatively small number of
smaller traders; (2) the close relationship between some futures and equity markets; (3)
the "zero-sum" nature of the market in which every dollar in profit to one person
represents a dollar in losses to another person; and (4) exclusive regulatory jurisdiction
by a single agency, the federal Commodity Futures Trading Commission.
Under the authority of the Commodity Exchange Act, the CFTC is charged with
overseeing the futures markets. In adopting the Act, Congress described its remedial
purpose:
The fundamental purpose of ttie Commodity Exchange Act is to ensure fair
practice and honest dealing on the commodity exchanges and to provide
a measure of control over those forms of speculative activity which too often
demoralize markets to the injury of producers and consumers and the
exchanges themselves.^
Courts which have examined the CEA have repeatedly cited the legislation's protective
purpose."' While I recognize that Members of this Subcommittee are well aware of the
history and purpose of this nation's commodity laws, I make this point so that you might
contrast the recent actions of the CFTC in exercising its new exemptive authority under
the Futures Trading Practices Act of 1992 (FTPA) with Congress' original purposes in
enacting the CEA.
^ See. 7 U.S.C. Section 5; S. Rept. No. 93-1131, 93d Cong., 2d Sess., 1974.
3
See , e.g., Commodity Futures Trading Commission v. British American Commodity Options Corp.,
788 F.2d 92, 94 (2d Cir.), cert, denied, 479 U.S. 853, 107 S.Ct. 186, 93 L.Ed.2d 120 (1986); Tamari v. Bache
& Co. (Lebanon) S.A.L.. 730 F.2d 1103, 1106 (7th Cir. 1984), cert denied, 469 U.S. 871, 105 S.a. 221,
83L.Ed.2d 151 (1984).
146
The CFTC is the exclusive regulator of futures contracts, options on futures and the
organized commodity exchanges (contract markets).^ As such, if the CFTC fails to
assert or exercise its jurisdiction in these areas, other regulators, including state securities
regulators, have very limited authority to act. When Congress acted in 1982 to amend
the CEA, it included the so-called "open season provision" (Sections 6d and 1 2e of the
CEA), which gave the states new authority to enforce the CEA in federal courts and to
move in state court against illegal off-exchange products and operators. These provisions
were carefully crafted by Congress and intended to foster a meaningful and effective
CFTC-state partnership in the policing of the legitimate and illegitimate marketplace. We
are concerned that the CFTC now seems to be taking steps to remove itself from that
partnership, leaving the states in the unenviable position of having to move in and clean
up the fraud that can develop due in large measure to deregulatory policies. Given the
very limited authority of the states under the CEA, the states find such a possibility
particularly disturbing. We ask you to consider the potentially devastating effects if
oversight of the futures markets is left to the extremely limited anti-fraud powers of the
states:
o If the CFTC removes itself from the partnership with the states, it will take
with it the extraordinary enforcement powers unique to that agency. At the
same time, we would lose the years of expertise that have been built up in
that agency;
o Only a federal agency such as the CFTC can move swiftly and effectively
to shut down fraudulent operations acting on a nationwide basis;
o It is unreasonable to expect the states to shoulder the burden of acting as
the sole enforcer of violations of the laws in this area when the states have
no voice in shaping the regulatory policies that may have the effect of
allowing these very violations or the effect of increasing the volume of fraud
and abuse; and
o It is fundamentally unfair to rely exclusively on the states to police the
marketplace when the states have been denied the authority to deter the
fraudulent or abusive behavior before it occurs. Is it not better to give law
enforcers the power to implement standards that will reduce the incidence
of fraud before it occurs. This is exactly the theory underlying the CFTC's
current authority to require trading on the exchanges and make it subject
to all of the statutory safeguards.
4
When Congress adopted the CEA in 1974, it preempted the states from applying their investment
laws to p>ersons and transactions deemed to be within the jurisdiction of the Act. In response to the virulent
outbreal< of commodity-related fraud in the late 1970s and early 1980s, Congress amended the Act in 1982,
permitting the states to police off-exchange commodities-related products and those selling them, if such
sales are illegal under the CEA. The states also may enforce some provisions of the CEA in federal court.
147
As a result, I am deeply concerned that during the past several years, the CFTC has
embarked on a course of abandoning and repudiating its responsibilities to protect the
integrity of the commodity futures markets and those who invest there. The CFTC's
action in exempting broad categories of energy products from the anti-fraud and anti-
manipulation provisions of the CEA is the most recent, and a most egregious, example
of this new course. Without active and vigorous oversight, the markets under the CFTC's
exclusive jurisdiction invite fraud and abusive trading.
Further, it would seem that the wiser course would be to adhere to Congressional intent
as evidenced by the history of the CEA, and to encourage trading toward the markets,
rather than the opposite, as the Commission seems to be doing. Congress has explicitly
required that all futures contracts be traded on designated exchanges. This exchange-
trading requirement is not the product of some fleeting Congressional whim. Rather, it
is the result of more than 70 years of Congressional experience with these markets.
The resulting regulatory framework works rather well in promoting market integrity,
providing price discovery of commodities, increasing liquidity in the markets,
and reducing the transaction costs of entering into futures contracts. The efficient
operation of these markets is vital to the domestic and, indeed, the global economy.
NASAA's support for encouraging trading on exchanges centers around two central facts:
(1) affirmatively doing so would help avoid market fragmentation; and (2) this type of
trading needs appropriate supervision, which is best accomplished by governmental
oversight of the exchanges. In the end, these markets are far too important to be entirely
overlooked by a vital regulatory agency.
WHAT TYPES OF FUTURES TRADING SHOULD BE REGULATED
Mr. Chairman, as you well know. Congress intentionally has declined to define the term
"futures contract" under the Commodity Exchange Act for fear that drawing such a
distinction would encourage the proliferation of products and schemes deliberately
designed to evade or avoid CFTC jurisdiction. Rather, it has been left to the courts and
to the CFTC itself to apply established case law and other tests in determining whether
a contract is a "futures" contract for purposes of the Act. In fact, it was only in the
Futures Trading Practices Act of 1992 that the CFTC was granted new exemptive
authority which frees the agency from having to make the "all or nothing" jurisdictional
decisions faced in the past. It was the hope of NASAA that the Commission would assert
this new exemptive authority judiciously and prudently in those cases where it was
determined that, in so doing, restraints on commerce would be reduced and markets
would be permitted to evolve. It was not expected that the authority would be used to
alter the Commission's overriding responsibility to protect the public interest.
148
However, and in retrospect, perhaps the Commission's most recent action should have
been anticipated. The agency's track record over the last several years clearly
demonstrates a disdain for using its regulatory powers to conduct oversight of unusual
or innovative products. It is instructive to examine the direction in which the CFTC has
moved in recent years. I, personally, have observed the CFTC's reluctance to exercise
the very authority it has fought so hard to reserve for itself.
Paragon Investment Company (P.I.E). In 1985, I learned about a gold and silver
margin investment scheme being offered in Idaho by California-based Paragon Investment
Company, also known as P.I.E. In inquiring about the investment, I was falsely told by
an account executive that if I invested, there would be no exit charges, no interest fees,
no charges for the unpaid balance, and that I could liquidate the contract whenever I
chose. The sales pitch included the ail-too familiar assurances: the price of silver would
shoot up the next day because OPEC ministers were expected to announce that they
were taking action to shore up the price of oil, thus causing the price of silver to increase;
the low price of silver made it almost impossible to lose; the price was fantastic and I
should buy now; most of the salesman's clients have experienced big profits; the big
brokerage houses had put out the biggest buy signals in a long time and I would be in
a safe position; the price of silver would shoot up astronomically due to unrest in South
Africa; and I would be dealing with a good, clean, legitimate company. An investigation
conducted by the Idaho Securities Bureau uncovered numerous false statements and
misrepresentations and exposed this as a fraudulent scheme.
I welcomed this opportunity to accept the CFTC's oft-repeated offer to bring joint
enforcement actions with the states. At the time, I was a Deputy Attorney General for the
State of Idaho, and I drafted a joint complaint to be filed in federal court on behalf of
Idaho and the CFTC against Paragon. Fortunately, the Paragon scheme was structured
in a way which allowed us to bring an action under the SEC laws, because after six
months of contradictory answers from the CFTC on whether they would join us in a joint
action, I gave up on the idea of acting together. Instead, I filed an enforcement
complaint on behalf of the State in state court under the Idaho Securities Act. During the
six months that we waited for the CFTC to get back to us, the fraud continued to prosper.
Ironically, our action attracted substantial print and television media attention in Los
Angeles. Reporters asked the then-Los Angeles Regional Director of the CFTC for
comments about our suit. His response was that the CFTC was conducting its own
investigation of Paragon. Indeed, a few weeks later, the CFTC did file its own suit in
federal court.
The State of Idaho received the injunction it sought. So did the CFTC, which additionally
obtained a receiver and a temporary restraining order. While our action halted
perpetration of the fraud in Idaho, only the CFTC's action had the effect of stopping the
practices nationwide. Cooperation here would have made great sense. Instead, we had
two duplicative actions going their own way, piling up expenses, and using far more
149
valuable time than would have been necessary had there been even elennentary
cooperation.
In the decision in this CFTC action, the court reaffirmed the characterization of a futures
contract, basing its rationale on the landmark Ninth Circuit decision in CFTC v. Co-Petro
Marketing Group . .^ Co-Petro held, in part, that futures contracts were characterized by
standardization of contract terms and the existence of conditions which facilitate the
formation of off-setting or liquidating transactions (allowing for non-delivery).
As I have stated, Congress deliberately left open the question of the definition of a futures
contract so that the courts and the CFTC would have maximum flexibility to apply the
CEA to all types of violative behavior. In 1990, however, and ironically, this flexibility
resulted in the Commission's rebuke of a federal Court. In Transnor (Bermuda) Ltd. v.
BP North America Petroleum, et al .^ the federal district court for the Southern District of
New York on April 18, 1990, ruled that certain oil contracts were indeed futures contracts
and subject to the provisions of the CEA, which requires that futures trading be
conducted on a designated exchange. This decision left participants in the Brent crude
oil markets in a state of uncertainty as to the legality of the transactions in which they
were engaged.
7776 CFTC Responds to Transnor . The CFTC's reaction to the Transnor decision
was quick, but beyond its authority and misguided. In its attempt to calm oil traders,
producers, and purchasers, the CFTC went too far. After the Transnor decision was
issued, the Commission promptly released an advisory indicating that the agency was
dedicated to maintaining access to the Brent market. The Judge in New York was sent
a letter and within a day was provided with a copy of the advisory by the CFTC's general
counsel. After this rather unusual signal to the Court, the Commission, less than a month
after the Transnor case was settled, voted to authorize the staff to complete a draft of a
legal interpretation. Shortly thereafter, another Commission advisory announced that a
draft legal interpretation was available upon request from the general counsel and that
comments on it would be received over a two week period. In short, the public, outside
of the special interest lobbyists, had little time to comment or otherwise offer its views.
Two months later, on September 25th, the final interpretation was published in the Federal
Register , having been adopted by a 3 - 1 vote.
680 F.2d 573 (9th Cir. 1982).
738 F.Supp.1472 (S.D.N.Y. 1990).
150
The Commission's action here had three major flaws:
o The CFTC presumed to overrule the federal district court in New York in the
Transnor case by the issuance of its own interpretation;
o The CFTC went beyond its legal bounds by dealing with a perceived
problem through a legally obscure procedure. In effect, the CFTC
attempted to change the law through a legal interpretation, rather than
following the law determined by Congress assume; and
o The Commission unilaterally announced a new set of criteria as to what
distinguishes a futures contract from a forward contract. These new criteria
were contrary to those set down by the courts and the CFTC in previous
actions.
The State of Idaho submitted a comment letter to the CFTC urging restraint:
The State's foremost concern is that an exclusion as described above,
unless narrowly drafted, could have far-reaching and objectionable effects.
As a regulatory agency with responsibility for investor protection, our task
would be made infinitely more difficult by [a] broad interpretation which did
not consider the enforcement ramifications of this issue7
The State urged the CFTC to carefully limit the scope of the exclusion contemplated in
the interpretation to "apply only in situations where a commercial party is purchasing for
its own use or inventory" and to limit the exemption to the Brent contracts. We cautioned
the Commission that a broadly drawn exclusion would legitimize fraudulent practices then
in use by some commodity firms.
It appears that the CFTC perceived itself to be between the proverbial "rock and a hard
place". It wanted to clarify the law with the goal of calming traders in the Brent Oil market.
On the other hand, it lacked the flexibility under the law to grant any exemption.
The CFTC's solution was a bad one. It decided to "overrule" the Transnor court and, in
effect, create an exemption. Since it lacked exemptive authority, however, it chose to alter
the traditional definitional elements of a futures contract. The Commission arbitrarily
announced, under the guise of merely "interpreting" the law, that a new standard now
existed. As a result, the CFTC interpreted away its own jurisdiction and disclaimed
authority over a broad category of products. The Commission seemed not to care that
by changing the definition of a futures contract, the new criteria threatened to shield
' A copy of the June 8, 1990, comment letter is attached. Unfortunately, many of our fears later were
realized.
151
8
fraud in the trading of other commodities -- a hefty price to pay for helping the oil
companies.
In reality, the Statutory Interpretation that was adopted was a broad pronouncement of
new policy. This was despite a strongly worded 27 page dissent by then-Commissioner
Fowler West.^ The irony of the Statutory Interpretation was that the CFTC usurped
judicial and Congressional authority -- then used that putative authority to deny itself
jurisdiction.
Unfortunately, since the CFTC has exclusive jurisdiction in this field, the states have
limited power to use the "open season" provision under the CEA to move against and
prevent fraudulent activities. We are compelled to live with these federal policies. If the
CFTC grants an exemption, ruling that the CEA does not apply to certain transactions or
products, it then also denies the states the ability to use the CEA to stop fraud in sales
of these products. Our only hope was that Congress would remedy the problem or that
the courts would recognize that the CFTC action exceeded its authority -- and disregard
the Statutory Interpretation. We were disappointed in the latter.
A-Mark Precious Metals. Keith Bybee, a sole proprietor buyer and seller of gold
and silver in Boise, began buying precious metals from A-Mark Precious Metals for resale
to customers. A-Mark convinced Bybee to open a margin account that consolidated
money belonging to him and his customers. A margin account such as Bybee's allowed
for substantial leverage in his speculative trading of precious metals. All trading was
required to be done in Bybee's name, not that of his customers. Some 95% of the
subsequent purchases were offset rather than resulting in delivery of metals.
By 1986, Bybee had suffered huge losses and A-Mark liquidated his account. As a result,
over one hundred small investors lost $2 million. Mr. Bybee was convicted in state court
of fraud and went to prison. In addition, my office obtained a court imposed judgment
and injunction against him. However, investors were left without restitution.
Both the bankruptcy trustee and the State of Idaho filed suit against A-Mark alleging that
its dealings with Bybee, while he was using customer monies, constituted the sale of
illegal off-exchange futures contracts. Our goal was to go after the commodity firm which
made Bybee's scheme possible in the first place. Despite our prior experience with
Paragon Investments, we still wanted to bring a joint enforcement case with the CFTC
under the 1982 amendments to the CEA. I received informal assurances from staff in the
CFTC's Division of Enforcement that they concurred with our legal analysis.
Unfortunately, the Commission would not respond to our request. Finally, we gave up
on a joint action and filed suit alone under the authority granted to the states in Section
Commissioner West's dissent from the Statutory Interpretation was refused publication by the CFTC
at the time of adoption of the Statutory Interpretation.
152
6d of the CEA. Our suit represented the first time that a state had acted alone to enforce
the CEA in federal court.
The suit by the bankruptcy trustee went to trial first. The district court, applying the
factors identified in Co-Petro and similar cases, held that the transactions were entered
into for speculative purposes with no expectation that delivery would occur and found that
all the elements of futures contracts existed but one -- the public was not involved.
With that conclusion, he ruled that the investments being sold were not futures contracts.
The district court's decision was appealed to the Ninth Circuit Court. Since it was this
same court that had decided both Paragon and Co-Petro . we had high expectations that
the court would find that a futures contract existed and perhaps even take the opportunity
to rule that the CFTC's Brent Oil Statutory Interpretation was ultra vires . We were wrong.
During the appeal, the State of Idaho submitted an amicus curiae brief to the court
arguing for continued application of the criteria set forth in the long line of cases defining
futures contracts. We encouraged the CFTC also to file an amicus brief. Its brief,
however, was limited to informing the court that public participation was not a necessary
element of a futures contract. In the meanwhile, we were advised that the CFTC's
general counsel had been actively soliciting amicus briefs opposing the position of the
State and the bankruptcy trustee that futures contracts were involved. Three parties filed
such briefs.
Relying heavily on the recently promulqated CFTC Statutory Interpretation, the Court of
Appeals issued an astounding opinion. Incredibly, it ruled:
o The A-Mark contracts were simultaneously futures contracts under the CEA
and forward contracts excluded from the CEA, pursuant to the Brent
Statutory Interpretation;
o That great deference should be given to the Commission's interpretation of
the CEA, even if it departs from well established case law; and
o The CFTC's "innovation" in its treatment of delivery obligations was adopted
for the A-Mark transactions, and so long as offsetting transactions are
"separate, individually negotiated, new agreements," there is no
standardization of contracts such that the instruments are covered by the
statute.
9
Krommenhock v. A-Mark Precious Metals Inc.: In Re Bvbee . 945 F.2d 309 (9th Cir. 1991).
153
10
Heretofore, the terms, futures contracts and forward contracts, had been mutually
exclusive. Contracts were either subject to the provisions of the CEA or excluded from
the CEA. This new decision, however, created an especially pernicious effect. By first
defining these contracts as futures contracts, the CFTC gained exclusive jurisdiction.
State laws generally would not apply. The securities laws cannot be used to proscribe
conduct. But, by then also finding them to be forward contracts, the CFTC is itself
deprived of jurisdiction. The A-Mark court was overwhelmingly successful in ensuring that
there will be absolutely no regulatory oversight of these contracts sold by A-Mark or of
any contracts structured in a similar manner.
This decision wrought a second major benefit for fraudulent commodity investment
schemes. As a result of this case, the concept of offset conducted off of an exchange -
- which was traditionally the touchstone of an illegal off-exchange futures contract - now
is legitimized. All that a scam must do is assert that all offsetting transactions are
separately negotiated and they will be unregulated forward contracts.
These results are directly contrary to the regulatory and legislative history of the CEA.
It may have a direct effect on the enforcement efforts of the CFTC. Since the A-Mark
decision, there seems to me to have been a significant decline in the number of "off-
exchange" enforcement cases initiated by the CFTC. State regulators also have been
impaired. The fears expressed in our June 1990 letter to the CFTC were all fulfilled - and
more.
FUTURES TRADING PRACTICES ACT of 1992
We had high hopes for a reversal of this trend with the passage of the Futures Trading
Practices Act of 1992 (FTPA). New section 4(c) of the CEA specifically authorizes the
CFTC to grant exemptions that meet a set of very narrow and stringent conditions.
NASAA generally supported the granting of this authority as it would enable the
Commission to authorize certain isolated trading without also sanctioning illegal conduct
that mimicked the outward trading styles of the exempted trades. it was our
expectation that the exemption would be considered only for those parties that requested
an exemption and demonstrated sound reasons why the CEA should not apply. This
would eliminate the need continually to contort the definition of a futures contract in order
to provide needed relief, as was the case in the Brent Statutory Interpretation.
See . November 6. 1991 letter from then-NASAA President Lewis Brothers, Jr. to Senator Patrick
Leahy regarding the Conference Committee's consideration of CFTC Reauthorization Legislation.
154
11
In addition, the Conference Report of the FTPA attempted to repair some of the damage
caused by the A-Mark decision by making legislative policy clear that:^^
o Products cannot be simultaneously futures contracts and forward contracts;
o The Co-Petro standards still should be used against fraudulent commodity
schemes; and
o States and other federal authorities are not precluded from asserting
jurisdiction over forward contracts, even if the CFTC lacks jurisdiction.
CFTC ENERGY EXEMPTION
The CFTC quickly demonstrated that it did not view its exemptive authority granted under
the FTPA as being limited in scope or to be used sparingly. Neither did it accept the
admonitions from the FTPA Conference Committee that the expansive definitions adopted
in A-Mark should be revisited with special consideration for its public policy implications.
NASAA had hoped and even expected the CFTC to use its new exemptive authority to
revisit the Brent Statutory Interpretation, making it more narrow -- especially in light of A:
Mark . Indeed, just the opposite has occurred.
On April 13th, the CFTC voted 2-1 to exempt certain energy products from its jurisdiction.
The exemption, as adopted, is extraordinarily broad. It covers transactions, products and
parties who never even requested application of the exemptive authority. It uses broad
language that I feel undoubtedly will assist fraudulent operations. In an unprecedented
move, the divided Commission proclaimed it did not even preserve for itself antifraud
jurisdiction.
Commissioner Sheila Bair dissented from adoption of this Rule, saying in part:
In my view, the final order, by its terms, is not limited to forward contracts
traditionally excluded from the jurisdiction of this agency. Rather, it goes
significantly beyond the forward contract exclusion and extends to
transactions which could very well meet the criteria for illegal off-exchange
futures contracts traditionally applied by this agency and the courts. I
believe that exempting such transactions from statutory provisions as basic
and central to our regulatory scheme as Sections 4b and 4o is a serious
misapplication of our new exemptive authority, and sets a dangerous
See Futures Tradino Practices Act of 1992 . Conference Report, U.S. House of Representatives,
102rxj Congress, 2d Session, Report 102-978, October 2, 1992, page 72.
155
12
precedent.
As this Subcommittee learned in its hearing on April 28, 1993, the CFTC's Division of
Enforcement and its Division of Trading and Markets recommended against such a broad
exemption while abdicating anti-fraud jurisdiction. If the views of these two divisions,
which have substantial expertise as well as the experience gained from real world
application of the law, are not heard, I fear that CFTC policies in general, and this
exemption in particular, have lost any relation to reality. Thus, it seems that deregulatory
theory alone drives Commission action.
A more serious effect of this exemptive rule is to discourage the use of reasonably
regulated and liquid U.S. futures exchanges. When the Commission encourages off-
exchange or off-shore trading in place of trading on the regulated exchanges, by granting
wholesale, broad exemptions, it cannot help but speed migration of trading from the
exchange floor. Indeed, the exchanges even can be beneficiaries of this regulatory
abdication. They now can trade off-exchange without government regulations - the same
regulations deliberately imposed by Congress as a result of fraudulent practices and
which are intended to protect traders, investors, and hedgers.
Why should we care? Who will complain? The beneficiaries of this largess include the
CFTC, large traders, the exchanges (to the extent that they take advantage of these off-
exchange opportunities) and, most sadly, promoters of fraudulent schemes who now can
structure their investments a certain way and operate with impunity.
Those who will suffer from this result are those whose voices are not being heard and
whose interests are not being protected by the CFTC:
o Individual investors victimized by fraudulent schemes now ignored by the
CFTC;
o Hedgers and speculators who trade on the regulated exchanges and now
will find less liquidity in their markets, more volatility, less efficient price
discovery (as fewer trades are reported on the organized markets), and an
increased risk of manipulated prices;
o The U.S. economy which relies on the organized exchanges for price
discovery of commodities, ample future supplies as indicated by commodity
price directions, and a source of actual commodities for delivery; and
o Regulators and other law enforcement authorities who have reduced abilities
to assert jurisdiction and apply the law to off-market trading - both
legitimate and illegitimate.
156
13
Sadly, those groups who will be most disadvantaged by this current action probably do
not yet know the deleterious effects they will suffer as a consequence.
RECOMMENDATIONS
We cannot emphasize enough the seriousness of our concern about the CFTC's actions.
This broad exemption is particularly intolerable with the disclaimer of anti-fraud jurisdiction.
The course must be reversed. To do so, NASAA would offer the following
recommendations:
o Prompt passage of H.R. 2374. This bill is absolutely necessary to mandate
preservation of anti-fraud authority both retroactively and prospectively;
o The CFTC should be directed to withdraw the 1990 Brent Statutory
Interpretation;
o Congress should consider requiring the CFTC to provide a reasonable,
scheduled review of this latest exemption then require each entity seeking
use of the exemption to make a separate, publicly available application for
exemption. Each application should be accompanied by an explanation as
to how the participant and the contemplated transactions satisfy the criteria
set forth in the Futures Trading Practices Act.
o The CFTC must take great care in granting exemptions on a broad, generic
basis without knowing who will be taking advantage of the exemptions. This
may help reduce the chance that the exemptions would be used by crooks.
It will also provide information to the CFTC about off-exchange trading with
which to evaluate the effects of the exemption. Moreover, it makes publicly
available such economic factors as the volume of, prices of, and parties
engaging in, such trading;
o Congress should require the CFTC to embrace the policies set forth in the
FTPA Conference Report regarding the distinctions between futures and
forward contracts, the continued validity of prior caselaw establishing the
futures contract definition, and the jurisdiction of other regulators;and
o Congress should consider prohibiting the CFTC from granting any
exemption from its oversight for transactions which are virtually clones of
products trading on regulated exchanges. This will prevent migration of
trading from the exchanges and the omission of trading data from the
financial markets.
157
14
NASAA has sent a letter to President Clinton expressing concern over the direction of the
CFTC.^^ Our letter urged the President to move quickly to fill the vacancies at the CFTC.
At the very least, we recommended that President Clinton immediately seek the CFTC's
agreement to make no further policy changes, such as this, until a full contingent of
commissioners has been approved -- individuals who will represent the views of this
Administration. We respectfully urge this Subcommittee to support the same goals.
CONCLUSION
NASAA appreciates the opportunity to present its views on this very important issue. We
commend you for taking steps to halt this regulatory abdication by an agency which was
entrusted with exclusive jurisdiction. We hope that the oversight process by Congress
will help prevent any further damage by this agency.
If the CFTC is allowed to continue on this path, it may be a very short path. If this
continues and only three more exemptive proposals are adopted -- one for financial
instruments, one for precious metals, and one for agricultural products -- there will be little
left to regulate. We can then disband the agency. At least then we could stop what has
become a cruel hoax on the American public -- that the markets are well protected and
that the government is acting in the best interests of the general public.
As the House Committee on Agriculture recognized in 1932:
So long as these markets are to be regulated as public markets and so long
as they operate under the apparent supervision of the Federal Government,
it seems proper that such supen/ision should protect the rights of customers
as fully as possible. ^^
(Attachments follow:)
" A copy of the letter dated June 2, 1993 is attached.
" H.R. Rep. No. 1551, 72d Cong., 1st Sess. Section 3, (1932).
72-584 0-93-6
158
NORTH AMERICAN SECl RITIES ADMINISTRA I '. )KS ASSOCIATION, INC.
AnACHMENT.
One MjvNjinuselts Avenue. N.W.. Suite .UO
Washineion. D.C inOOl
^^^^ :o:/737-nwo
Telecopier: :n:/78.<-.<.=:T|
NASAA -
itjrrv r. (;ulharv. President
llirector. Securities Divisiun
' mt- \shhurton Place. I7lh Floor
Uoston. Massachusetts 02 1 IIK
(617l727..X54)t
June 2, 1993
Honorable William J. Clinton
The President
The White House
Washington, DC 20500
Dear Mr. President:
CXi bfhnlf of the North American Sei^urities Administrators Association, ^
we urge that prompt attention be focused on filling vacancies at the
Commodity Futures Trading Commission (CFTC) . There are currently, as a
practical matter, three vacancies in existence; although the position of
acting-chairman presently is filled by a ccmmissioner vtiose term hcis expired.
The acting-chair has indicated that he will depart in August, 1993.
The CFTC has a critical regulatory role, not only because it oversees
the large futures industry, but eilso because it has the exclusive regulatory
authority over futures contracts, unlike the regulatory scheme for the
securities industry, where the states and the Federal government share
oversight duties. As a result, the CFTC alone is responsible for the
approval of innovative financial products, the curbing of destructive
fraudulent trading schemes, and the promotion of stability and liquidity in
the trading of financial derivatives.
Mr. President, the CFTC has the (^:portunity to promote innovation, but
there must be a balemce struck between promoting financial innovation and
safeguarding the public. A strong CFTC is especially desirable because of
its oversight of stock index futures and various forms of program trading,
which impact the equity markets.
In the U.S., the North American Securities Administrators
Association (NASAA) is the national voice of the 50 state agencies
responsible for investor protection and the efficient functioning
of capital markets at the grassroots level.
Prestdcnl: B«rr* C. Gulliirv tMiss«chusct(i> • PrFiideni Elect; Crii| A. Gocllscit llowii • secretary: Weslev L. Rlngo (UKconMn> • I ri-asurer; Wivne Klein ildalioi
Direclon: Lewis W Brotliers. Jr. iMrtlniai • Khilip A. Felfin (Colorado) • Marcel de la (;or||endlere isaikau he« jn i • vlarh J. tinffln iNevada*
Richard D. Laltiaoi iTeiafi
159
Honorable William J. Clinton
The White House
June 2, 1993
Page 2 of 4
The CFTC's role in safeguarding the integrity of the commodity
futures market should not be underestimated. One of the CFTC's
primary roles is to assure that there is no manipulation of prices
on the futures exchanges. Any dysfunction of the commodity futures
markets could have a devastating and global impact on market prices
for a wide range of commodities. Finally, whilfe recognizing that
over-regulation can hurt the marketplace, great harm also can come
from too little regulation.
Mr. President, recent actions taken by the CFTC have caused
great concern among state regulators and within Congress. Under
exemptive authority^ provided in its most recent reauthorization,
the CFTC, on April 13, 1993, completely dismissed from oversight
and regulation a large number of energy products. These products
are believed by many to be futures contracts, which should be
traded on a futures exchange. While some use of the exemptive
authority in this area was encouraged by Congress in the CFTC's
reauthorization, the CFTC surprised most observers, including the
states and its own Division of Enforcement, by going so far as to
exempt these products from even its anti-fraud rules. In short,
the CFTC appears to have served notice, in advance, that it will
not intervene even if faced with patently fraudulent activity in
this area.
The CFTC's recent action greatly expands a controversial legal
interpretation issued by the CFTC in 1990, involving the Brent Oil
markets.^ That action directly opened the door to potential abuse"
^NASAA supported this grant of authority as a means of
permitting appropriate, narrow exemptions in contrast to the
prior pattern of wholesale abdication of its responsibilities.
However, this new power is being badly misused.
'in September of 1990, the CFTC issued a statutory
interpretation tailored to protect oil companies involved in the
so-called Brent Oil market. The U.S. District Court for the
Southern District of New York had found Brent Oil contracts to be
illegally traded futures contracts. The CFTC's interpretation,
which passed by a 3 to 1 vote, essentially purported to overrule
the court decision. The interpretation declared the Brent
contracts to be forward contracts, not futures contracts, by
substantially revising the definitional criteria of what
constitutes a forward contract and a futures contract under the
Commodity Exchange Act.
160
Honorable William J. Clinton
The White House
June 2, 1993
Page 3 of 4
of consumers.* Many states are quite concerned that the exclusive
jurisdiction enjoyed by the CFTC, coupled with the CFTC's
continuing rush toward deregulation, makes it very hard to provide
adequate consumer protection in the commodity futures area.
The vote at the CFTC to grant this broad exemption was 2 to 1.
That controversial action led to a hearing by a subcommittee of the
House Agriculture Committee, chaired by the Honorable Glenn
English, who expressed great concern at the deregulatory
recklessness displayed by the CFTC. Mr. English stated at the
hearing that the CFTC's action went beyond the authority granted by
Congress. He added, "of the 18 years I've been in Congress, this
is the most irresponsible decision I've come across."
The states feel that the opportunity to appoint three members
to the CFTC should be taken as soon as possible. In particular, a
chairman should be nominated without further delay. Special
attention should be given to nominating individuals who are
dedicated to protecting the public and to providing a proper
regulatory balance.
Over the past few years, the states have seen their relations
with the CFTC gradually improve, but the recent trend at the CFTC
has caused considerable concern. The states have been a willing
participant with the CFTC's Advisory Committee on CFTC-State
Cooperation, but changes of commissioners at the CFTC have rendered
that committee inactive. Our concern is that a lack of action in
*Relying heavily on the CFTC's Brent interpretation, the
Ninth Circuit Court of Appeals in California, in 1991, declared
that certain precious metals transactions were both forward and
futures contracts. This meant that they were subject to the
exclusive jurisdiction of the CFTC — and thus no other regulator
could assert jurisdiction. Incredibly, it also meant that it was
exempt from CFTC oversight. As a result, no regulatory authority
could assert jurisdiction. This ruling thwarted the State of
Idaho's efforts to stop what it felt to be a precious metals scam
against its citizens which has resulted in the loss of three
million dollars.
161
Honorable William J.
The White House
June 2, 1993
Page 4 of 4
Clinton
filling these vacancies will cause a further deterioration at the
agency, which is the sole regulator of a large, and oftentimes,
volatile futures industry. It is that volatility, combined with
the importance of the futures markets, that demands competent and
dedicated commissioners.
Respectfully, NASAA requests that you fill these CFTC
vacancies with individuals whose goal it is to judiciously
regulate, with an appreciation for the primary purpose of the CFTC,
protecting the users of the futures markets.
We pledge our full assistance to you as you deal with the
financial regulatory area. The executive director of NASAA, Fowler
West, just completed two terms as a CFTC Commissioner. His leaving
the CFTC greatly reduced the CFTC's focus on investor protection at
the commissioner level. This situation needs to be addressed by
filling these three vacancies with commissioners who believe in
investor protection. NASAA looks forward to your appointments and
to working closely with a restored CFTC.
Sincerely,
Barry C. Guthary
President
Cr^^ Ai Goetttsch
P^esid^t El96t
162
H^2
CECIL D ANDRUS
GOVERNOR
BELTON J PATTY
DIRECTOR
ATTACHMENT.
jy;; i ;
STATE OF IDAHO
DEPARTMENT OF FINANCE
BOISE, IDAHO 83720
(208)334-3313
June 8, 1990
Wendy L. Gramm
Chairman
Commodity Futures Trading Commission
2033 K Street, N.W.
Washington, D. C. 20581
Re: CFTC Policy Interpretations on Trans nor
Dear Chairman Gramm:
The State of Idaho Department of Finance ("State") wishes to
express to you the serious reservations it has concerning pro-
posed CFTC action in the wake of the Transnor (Bermuda) Limited
V. BP North America Petroleum, et al. , 86 Civ. 1493 (WCC)
(S.D.N.Y.) ( " Transnor " ) decision.
Our understanding is that the Commission intends to issue an
interpretation of the Commodity Exchange Act ( "CEA" ) concluding
that the 15-day Brent contracts fall within the "forward con-
tract" exclusion contained in Section 2(a)(1)(A) of the CEA.
This conclusion is based upon representations to the Commission
staff that the 15-day Brent contracts are not offered or sold to
the general public, and are negotiated transactions between
commercial parties, each of whom is able to make or take delivery
of Brent crude oil.
The State's foremost concern is that an exclusion as
described above, unless narrowly drafted, could have far-reaching
and objectionable effects. As a regulatory agency with respon-
sibility for investor protection, our task would be made infi-
nitely more difficult by an broad interpretation which did not
consider the enforcement ramifications of this issue.
As you may know, the State of Idaho currently has a case
pending in the U. S. District Court for the District of Idaho,
State of Idaho v. A-Mark Precious Metals, Inc., et al.. Civil No.
89-1055 , which states a claim under the CEA. A decision on the
futures contract issue is imminent. Central to this case is a
determination as to whether the transactions between A-Mark, a
anks anc 5&L s
fed't Unions
oneciton Agencies
1208133^-3678
(2061334.2896
12081 33<-29-l5
>AHO
1890-CENTENNIAI-1990 "
EQUAL OPPORTUNITY EMPLOYER
Securiites
Wano CreO<t Cooe
SuDPOfting Services
(208) 334-368-1
(20ei33':-29a5
(208)234-33ii
163
Wendy L. Gramm
Page 2
June 8, 1990
precious metals wholesaler, and its customer, a precious metals
retailer, were off-exchange futures contracts. Of concern is the
fact that the retailer acted as a middleman or "broker" for A-
Mark to facilitate speculation by individual customers in the
metals markets. A-Mark also acted as an exchange in offsetting
and clearing the various long and short trades. Because none of
the regulatory protections of the CEA were in place, over a
hundred small investors lost approximately $2 million.
A-Mark knew that individual investors were participating in
its margin trading program and apparently encouraged the prac-
tice. Moreover, we disagree that the "Mom and Pop" coin dealers
in Idaho that used the A-Mark margin program were true commercial
users which are able to fend for themselves without the protec-
tions afforded by the CEA.
The analysis and conclusions of Transnor are not only very
helpful to us in the A-Mark case, but very useful from an en-
forcement perspective. Judge Conner's opinion on the definition
of a futures contract is well-reasoned and soundly grounded in
both federal and CFTC caselaw. We fear an overly-broad interpre-
tation of Transnor may not only have serious implications for our
own case, but could legitimize the practices engaged in by A-
Mark. VJe urge the Commission to be very cautious in this area.
We are asking that any interpretation issued by the
Commission incorporate the following concepts:
(1) The exclusion should only apply in situations where a
commercial party is purchasing for its own use or inventory. The
exclusion should not apply where a commercial buyer is purchasing
on behalf of its customers, i.e., where the contracts are offered
or sold directly or indirectly to the public. If commercial
entities are permitted to act on behalf of their own customers,
they in essence function as the exchange without meeting the
registration or regulatory requirements of the CEA, and individ-
ual investors are not afforded the protections Congress intended
they have.
(2) The exception should be limited specifically to the
Brent contracts.
We understand that Brent trading involves numerous consider-
ations aside from the futures contract/forward contract issue.
164
Vendy L. Gramm
Page 3
June 8, 1990
We hope, however, that the Commission will be mindful of the
critical role both it and other agencies play in maintaining the
integrity of the markets for small and large investors. Perhaps
a lesson can be learned from the now infamous #85-2 release that
a narrowly drawn interpretation is less likely to create serious
gaps in the enforcement structure. We believe a narrow exception
for Brent contracts can be constructed without opening the door
to allow every commodity contract entered into between commercial
parties to fall within the forward contract exclusion.
We understand that the Commission is under a fairly tight
time frame on this issue. We, however, are concerned about the
collateral impact of the decision being contemplated. I will be
in Washington, D. C. on June 18 and 19 and would be pleased to
meet with you or your staff to provide further information. If
CFTC action is expected before that time, I would be willing to
come to Washington the week of June 11.
Please contact me if we can be of any assistance during
this process. We view this as a critical area and are anxious to
see a proper end result.
Sincerely,
WAYNE KLEIN
Bureau Chief, Securities Bureau
Department of Finance
WK/MTS/drc
cc: Commissioner Fowler C. West
Commissioner William P. Albrecht
Commissioner Robert R. Davis
Commissioner -Kalo A. Hineman
Lee Poison, NASAA
J
165
H.R. 2374
Written Statement of Kenneth M. Raisler
On Behalf of the Energy Group to the
Subcommittee on Environment, Credit and Rural Development
Committee on Agriculture
U.S. House of Representatives
June 30, 1993
On behalf of the entities listed in the attached Appendix (collectively, the
"Energy Group"), I am pleased to submit this testimony on H.R. 2374, a bill to amend the
Commodity Exchange Act to require the continued application of the Act's anti-fraud and anti-
manipulation provisions. Each of the members of the Energy Group is a producer, processor
and/or merchandiser of crude oil, condensates, natural gas, natural gas liquids or their
derivatives, or is otherwise engaged in a commercial business related to such commodities.
The Energy Group comprises integrated oil and gas companies as well as refiners and suppliers
of such commodities, and each of the members of the Energy Group is an active participant
in the principal domestic and international markets for crude oil and/or natural gas and the
products and by-products thereof.
As the applicants for the Commodity Futures Trading Commission's Exemption
for Certain Contracts Involving Energy Products, 50 Fed. Reg. 21286 (April 20, 1993), the
Energy Group wants to make it clear that we are adamantly opposed to any form of fraud in
our markets. Our view, however, is that the bill before the Subcommittee, which removes
the CFTC's discretion to grant an exemption from the Commodity Exchange Act's (the "Act")
anti-fraud and anti-manipulation provisions, is not an effective way to address the issue. We
appreciate the Subcommittee Chairman's invitation to receive our views and hope that this
166
testimony may clarify some of the misperceptions about the energy markets, the scope of the
CFTC's Exemptive Order and its decision not to apply its anti-fraud jurisdiction. In our view,
the CFTC should retain the discretion granted in the Futures Trading Practices Act of 1992
(the "FTPA") in order to provide legal certainty and stability in appropriate markets.
The CFTC's authority to grant exemptive relief is provided in Section 502 of the
FTPA, which added a new Section 4(c) to the Act and granted the Commission the authority
to exempt "any agreement, contract, or transaction (or class thereof)" from the off-exchange
trading prohibition imposed under Section 4(a) of the Act and from any other provisions of the
Act. The provision "is designed to give the Commission broad flexibility in addressing these
products either generically or on an individualized, case-by-case basis." H.R. 978, 102d
Cong., 2dSess. p. 81 (1992) (the "1992 Conference Report"). The 1992 Conference Report
makes the further point that, "[t]he goal of providing the Commission with broad exemptive
powers ... is to give the Commission a means of providing certainty and stability to existing
and emerging markets so that financial innovation and market development can proceed in an
effective and competitive manner." At no time in the lengthy debate on CFTC Reauthorization
was it ever suggested that the CFTC's exemptive authority should be limited (other than with
respect to securities derivatives) or that the CFTC should not have authority to exempt
transactions from its anti-fraud and anti-manipulation jurisdiction. For the reasons set forth
in this testimony, we see no basis to upset the careful work of Congress in the FTPA so
recently enacted. To limit the CFTC's discretion, as suggested in H.R. 2374, could serve to
undermine the legal certainty and stability that Congress sought to achieve in granting the
CFTC broad exemptive powers.
Our testimony addresses the retroactive application of H.R. 2374 to the CFTC's
Exemptive Order for Energy Contracts. This is the only situation to which the bill would apply
-2-
167
and, to our knowledge, is the only situation where it is currently contemplated to apply.
Thus, while there may be other special situations where the CFTC may elect to exempt
contracts from the anti-fraud or anti-manipulation provisions of the Act, our testimony only
addresses the bill as it applies to Energy Contracts.
The FTPA
The Act generally prohibits the trading of futures contracts in the United States
other than on a designated "contract market", and futures contracts traded off-exchange
might therefore be found to be in violation of the Act. Act, § 4(a). Pursuant to Section
2(a)(1) of the Act, however, this prohibition does not apply to "any sale of any cash
commodity for deferred shipment or delivery", commonly known as a "forward contract". In
reliance on the forward contract exclusion, commercial entities have, throughout the history
of the Act and its predecessor statutes, routinely entered into a variety of off-exchange
transactions in connection with their regular business activities with the understanding that
such transactions were outside the scope of the Act and Commission regulations.
As Congress noted in the 1992 Conference Report, however, a District Court
in 1990 found that certain contracts for the forward purchase and sale of Brent blend crude
oil, referred to as " 1 5-day Brent contracts" , were futures contracts. 1 992 Conference Report
at 82, citing , Transnor (Bermuda) Limited v. BP North America Petroleum . 738 F. Supp. 1 472
(S.D.N.Y. 1 990) (" Transnor "). That decision, the first such decision in the history of the Act
which found that contracts entered into solely between commercial entities could be
construed to be futures contracts, created substantial confusion and uncertainty regarding the
legal status of a wide variety of legitimate and longstanding commercial practices in the
energy markets. As a result of the Transnor decision, many participants in the Brent market
and other commercial energy markets either ceased their trading activities completely or
168
restricted their activities to areas outside the United States. Those U.S. participants in the
Brent marlcet which were unable to trade from locations outside of the United States found,
in many instances, that non-U. S. counterparties simply refused to deal with them. The result
was a reduction in the level of 15-day Brent transactions, along with a reduction in trading
in other oil markets, and a significant impairment of hedging and other commercial
opportunities for energy market participants. This in turn adversely affected energy users and
consumers.
In response to the adverse effects of the Transnor decision, and in an effort to
clarify that 15-day Brent transactions and other similar agreements are outside the Act and
Commission jurisdiction, the Commission issued a statutory interpretation in September 1 990.
Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (Sept. 25,
1 990) (the "Statutory Interpretation"). The Statutory Interpretation represented an important
and essential step in resolving the uncertainties generated by the Transnor decision, and the
Energy Group strongly supports its continued validity. While the Statutory Interpretation gave
comfort to many market participants, uncertainty remained, particularly among foreign-based
oil companies who refused to enter into transactions with U.S. -based counterparties because
of their concern about the application of Commission jurisdiction.
In the course of its deliberations on the FTPA, the Congressional conferees
acknowledged the effect of the Transnor decision and the uncertainty that remained after the
Commission's issuance of the Statutory Interpretation in response to that decision. 1992
Conference Report, at 82. Congress noted that "[m]any markets of this nature are
international in scope; foreign parties are already engaging in such transactions free of
restraints imposed by the Act that may create competitive disadvantages for U.S.
participants". Id. In granting the Commission exemptive authority by the adding of a new
-4-
I
169
Section 4(c) of the Act, Congress stated that it "expect[sl and strongly encouragelsl the
Commission to use its new exemptive powers promptly upon enactment of this legislation in
four areas where significant concerns of legal uncertainty have arisen: (1 ) hybrids, (2) swaps,
(3) forwards , and (4) bank deposits and accounts." jd. at 81 (emphasis added). Thus, having
been given broad exemptive authority. Congress expected and strongly encouraged prompt
Commission action to address transactions which might not have been sufficiently clarified
by the Statutory Interpretation.
CFTC Energy Exemption
On November 16, 1992, the Energy Group submitted its application for
exemptive relief for certain contracts for the deferred purchase and sale of energy-related
commodities. The application took into account the different interests that are addressed by
CFTC anti-manipulation and anti-fraud jurisdiction. Recognizing the CFTC's historic and
continuing interest in protecting against manipulation in both the futures and the related cash
markets, the application proposed that the CFTC's anti-manipulation jurisdiction not be
restricted with respect to energy transactions. Because the CFTC had never overseen energy
physical market participants who, as substantial commercial parties, could protect themselves,
the application did not request that the CFTC apply its anti-fraud jurisdiction. In both
respects, the application was consistent with the Statutory Interpretation.
On January 27, 1993, after the publication of the Commission's final rules
exempting swaps and hybrid instruments (which included bank deposits and accounts), the
Commission's proposed Order exempting certain contracts involving energy products was
published. 58 Fed. Reg. 6250. The proposed Order was limited to "commercial participants
who, in connection with their business activities, incur risks related to the underlying physical
commodities, have the capacity to make or take delivery under the terms of the contracts, and
-5-
170
are also eligible 'appropriate persons'" as defined in the proposed Order (including entities with
a net worth exceeding $1,000,000 or total assets exceeding $5,000,000). The proposed
Order was limited to "bilateral contracts between two parties acting as principals" which
"[i]mpose[d] binding obligations on the parties to make and receive delivery of the underlying
commodity or commodities, with no right of either party to effect a cash settlement of their
obligations without the consent of the other party". Specified contracts which provide for
settlement of the obligations in a manner other than by physical delivery were permitted in
the proposed Order. The Order proposed to apply the CFTC's anti-manipulation jurisdiction
but not its anti-fraud jurisdiction. In addition to issuing the proposed Order, the Commission's
Federal Register notice identified particular issues for comment. These included the question
whether "Energy Contracts as described in the release [should] be exempt from section 4b
of the Act (the anti-fraud provision]".
Sixteen comments were received by the Commission including eight from active
participants in the energy cash or forward markets or entities representing such participants,
three from futures exchanges, three from futures industry associations, one from a bar
association committee and one from an attorney. All but one of the commenters generally
supported issuance by the Commission of the proposed Order. No commenter explicitly
supported the application by the Commission of anti-fraud jurisdiction. To the contrary,
almost all of the commenters opposed applying this authority. The commenters were of the
general view that given the commercial characteristics of these transactions and the
significant requirements to participate, section 4b of the Act (anti-fraud) should not be applied
to Energy Contracts. Commenters observed that since such transactions generally are
recognized to be forwards excluded from the Act and the Commission's jurisdiction,
participants have not had any expectation of protection afforded by the Act or the CFTC.
171
Instead, they have relied on existing statutory and common law prohibitions; imposing an
additional standard of liability would be duplicative and unwarranted.
At a public meeting on April 1 3, 1 993, the Commission adopted its Final Order
providing for an Exemption for Certain Contracts Involving Energy Products (the "Exemptive
Order"). The exemption was adopted by a 2-1 vote, the concern of the dissenting
Commissioner being that the Commission should apply its anti-fraud jurisdiction. The
Exemptive Order closely followed the terms of the proposed Order and did retain anti-
manipulation jurisdiction. The exemption covers contracts for the purchase and sale of crude
oil, condensates, natural gas, natural gas liquids, and products derived from such commodities
which are used primarily as an energy source. Contracts must be bought and sold by
commercial participants, as defined in the Order, be bilateral contracts between two parties
acting as principals, and impose binding obligations on the parties to make and receive
delivery without a right of either party to effect a cash settlement without the consent of the
other party (subject to the parties' rights to enter into specified contracts for settlement of
their obligations in a manner other than by physical delivery). It is the view of the Energy
Group that the exemption provides the legal certainty that Congress directed the Commission
to achieve for commercial contracts in the energy markets. The legal certainty that the
Commission has provided in its Exemptive Order will avoid potential litigation and allow U.S.-
based energy companies to enter into transactions in these markets with foreign-based
companies that, without the Order, have refused to trade because of their concern about the
application of CFTC jurisdiction.
Anti-Fraud Jurisdiction
We reiterate our strongly held position that there is no place for fraud in the
energy markets. Our view, however, is that H.R. 2374, by directing the CFTC automatically
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172
to apply anti-fraud jurisdiction, will not achieve its desired results. Instead, it will create false
perceptions and confusion that may deter important participation in the markets.
The CFTC's anti-fraud provisions only apply to transactions that the CFTC
determines are subject to the Act. The commercial buying and selling of goods, including
energy, have long been outside of Commission and generally federal government regulation.
The transactions described in the Exemptive Order are generally recognized by the CFTC and
others to be forward contracts outside of the CFTC's jurisdiction. The CFTC's Order does not
seek to expand the types of transactions or range of participants currently in the physical
energy markets. Instead, the exemption only seeks to provide legal certainty that these
activities which have been ongoing without CFTC oversight or involvement are clearly outside
of the CFTC's jurisdiction. While there is no evidence of fraud in the traditional physical
energy markets covered by the Exemptive Order, if fraud were to occur, CFTC jurisdiction
would almost certainly be ineffective. The CFTC does not have the staff or the expertise to
police the physical energy markets and retaining anti-fraud jurisdiction could create the
misleading impression that it is able to do so. Rather than expecting the CFTC, with its
limited jurisdiction and resources, to oversee these markets and protect against fraud,
participants and authorities should seek recourse under other clearly applicable state and
federal statutes, including those providing for criminal sanctions.* in addition.
Indeed, the Final Order is fully consistent with the
recommendation of this Committee, which was adopted into law
in the Futures Trading Act of 1982, to amend the definition of
"commodity trading advisor" to eliminate potential Commission
jurisdiction (including anti-fraud jurisdiction) over persons
who advise with respect to cash commodities or their- value,
including advice to individual members of the general public
regardless of net worth. Futures Trading Act of 19 82, Sec.
201; H.R. Report No. 97-565, 97th Cong., 2d Sess. 130 (1982).
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173
counterparties, of course, can rely on an existing body of commercial contract laws and state
and common law fraud statutes as the basis to litigate their disputes.
It is important to recognize that the Exemptive Order does not permit activities
that could be the cause of public fraud. For example, boilerrooms, generally recognized as
enterprises that use high-pressure sales tactics to solicit the general public, clearly are not
eligible for an exemption under the terms of the CFTC's Order. The general public and,
indeed, individuals are not eligible for the exemption. Both parties to each energy transaction
must be commercial participants who have substantial net worth or assets ($1 million/$5
million) to be eligible. Moreover, entities "formed solely for the specific purpose" of taking
advantage of the exemption are not eligible. Therefore, otherwise ineligible parties cannot
circumvent the exemption by creating a separate trading vehicle. Public "marketing" and
"sales", whether high-pressure or not, also are clearly outside the intended scope of the
Exemptive Order. Because a boilerroom marketing energy products would not qualify for the
exemption under the specific terms of the Exemptive Order, the CFTC would have available
its full array of enforcement authority, including its anti-fraud authority.
Furthermore, the CFTC's anti-fraud statute covers fraud committed by one
person acting "for or on behalf of" another. It is designed to address activity by a person,
such as a broker, who is generally in a stronger bargaining position than its customer, and
incurs specified legal duties to the customer as a result of their relative positions. There are
no "customers" that can be eligible for the Exemptive Order. The Exemptive Order only
applies to "bilateral contracts between two parties acting as principals," each commercials
with a connection to the energy business. In essence, the CFTC's fraud provision has no
application to transactions eligible for the Exemptive Order. To imply otherwise expands the
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174
scope of the Exemptive Order to exempt transactions that should be governed by all of the
provisions of the Act.
Congress directed the CFTC to use its exemptive authority to address legal
uncertainty in the "forwards" area. It is important to keep in mind that transactions covered
by the Exemptive Order are or closely resemble "forw/ard" contracts which have never been
subject to CFTC anti-fraud jurisdiction or any other provisions of the Act. The narrowly-drawn
Exemptive Order for Energy Contracts, as issued, without the application of the CFTC's anti-
fraud jurisdiction provides needed legal certainty. In so doing, it avoids competitive
disadvantage for U.S. participants whose foreign counterparts, no longer confused about the
applicability of the Act, will not be reluctant to enter into Energy Contracts in the U.S. This
result provides important benefits to U.S. energy companies (and energy consumers) by
promoting greater certainty in the sourcing of supply and pricing of purchases and sales of
crude oil, natural gas and products.
Conclusion
For the reasons stated, we cannot endorse H.R. 2374 insofar as it would require
the application of the anti-fraud provisions of the Act to all exemptions the CFTC may issue.
We endorse the goal of Congress in the FTPA to give the CFTC "broad exemptive powers"
to "create legal certainty" and "stability" for markets such as the energy markets. There is
no evidence that the CFTC has or will abuse its powers. The advantage of the FTPA
structure, as illustrated by the three exemptions that the Commission has issued to date
(swaps, hybrids and forwards), is that the CFTC can tailor each exemption to the particular
market. To the extent that there are unintended effects of the Exemptive Order for energy
products, which we see no basis to occur, the CFTC can always revisit it to tighten the
restrictions on who can participate in these markets or to clarify the terms of exempt
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transactions. To rigidly apply the Act's anti-fraud provisions serves to undermine the goals
of legal certainty and stability without achieving any other public benefits. I appreciate the
opportunity to present this testimony. Should the Committee have any questions, I will be
pleased to respond on behalf of the Energy Group.
(Attachment follows:)
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Appendix A
BP Oil Company
Coastal Corporation
Conoco Inc.
Enron Gas Services Corp.
J. Aron & Company
Koch Industries Inc.
Mobil Sales and Supply Corporation
Phibro Energy Division of Solomon Inc.
Phillips Petroleum Company
177
ISDA
1270 Avenue of the Americas
Suite 2118
Rockefeller Center
New York, New York 10020-1702
(212) 332-1200
INTERNATIONAL SWAP DEALERS ASSOCIATION, INC. FAX (212) 332 1212
June 30, 1993
Honorable Glenn English,
Chairman,
Subcommittee on Environment,
Credit and Rural Development,
Committee on Agriculture
U.S. House of Representatives
Room 1301, Longworth House Office Building
Washington, D.C. 20515
Dear Congressman English:
We appreciate the opportunity to comment on
H.R.2374, which is being considered by your subcommittee.
As you know, the International Swaps and Derivatives
Association (formerly the International Swap Dealers
Association) is an international association that represents
over 150 firms that participate in swaps and other
derivative transactions.
The purpose of this letter is to express several
reservations and concerns that we have regarding H.R.2374.
First, the Futures Trading Practices Act of 1992 (the
"FTPA") sought to promote legal certainty by vesting the
Commodity Futures Trading Commission (the "CFTC") with broad
exemptive authority. By providing the CFTC with this
authority. Congress permitted the CFTC to fashion the terms
of an exemption without necessarily having to resolve often
difficult questions concerning the jurisdictional scope of
the Commodity Exchange Act (the "CEA"). H.R.2374 would cut
back on this broad authority less than seven months after it
178
was enacted. We believe that this would undermine an
important goal of the FTPA. As the Conference Report
states, "[i]n granting exemptive authority to the
[CFTC] . . ., the Conferees recognize the need to create
legal certainty for a number of existing categories of
instruments which trade today outside of the forum of a
designated contract market (H.R. Rep. No. 978, 102d Cong.,
2d Sess. (1972) at 80) .
Second, we believe that it is appropriate for the
CFTC to retain the power, which Congress granted to it in
the FTPA, to determine, on a case by case basis, whether to
grant exemptions from the anti-fraud and anti-manipulation
provisions of the CEA. The Bill by its terms contemplates
that the CFTC may grant exemptions from these provisions in
cases where Federal banking and securities laws apply. We
believe that the CFTC should maintain the authority which it
now has to grant such exemptions in other circumstances it
deems appropriate as well. Under the FTPA, the exemptions
may only be granted where the CFTC concludes that it is
consistent with the public interest to do so. This Includes
any exemption from exercising anti-fraud or anti-
manipulation authority over particular transactions or
persons. We believe that the public interest test will
ensure that the CFTC ' s exemptive authority will be used
judiciously.
Third, we believe that the enactment of H.R. 2374
could create confusion as to its applicability to certain
exemptions already granted by the CFTC. In particular, it
is not clear whether the Bill would require a change in the
exemption for swap agreements that is contained in
Section 35.2 of the CFTC ' s regulations (17 C.F.R. S 35.2).
That exemption expressly provides that certain specific
anti-fraud and anti-manipulation provisions will remain
applicable to swap agreements that, absent the exemption,
would otherwise be subject to CEA jurisdiction. The
confusion arises because H.R. 2374 refers only to "anti-
fraud" and "anti-manipulation" provisions of the CEA; it
does not specify whether the sections enumerated in the swap
exemption are the ones contemplated by H.R. 2374.
Fourth, we believe that any amendment to the CEA
that would alter the regulatory structure that applies to
swap agreements, hybrid securities and other off -exchange
transactions should await completion of the studies now
being conducted by the General Accounting Office, the CFTC,
the Securities and Exchange Commission and the Group of
179
Thirty concerning these transactions. As the Subcommittee
is aware, the Conference Report on the FTPA specifically
contemplated that these studies be undertaken in order to
determine if there is a need for additional legislation.
Fifth, we note that H.R.2374 would require the
CFTC to implement its provisions through the issuance of
interim final regulations. Such a process would eliminate
the opportunity for prior notice and public comment. We
believe it would be more appropriate to require advance
notice and an opportunity for public comment. Among other
things, we believe that the CFTC should have the benefit of
public comment before determining how the anti-fraud or
anti-manipulation provisions of the CEA will apply in the
context of a particular rulemaking.
We will be pleased to respond to any additional
questions that the Subcommittee may have.
Sincerely,
■ / '' I : >///.. '
Joseph Bauman,
Chairman,
International Swaps and
Derivatives Association
180
coMe<
;OMMODITY EXCHANGE. INC . FOUR WORLD TRADE CENTER. NEW YORK.N Y. i0048m'212) 938-2919
FAX (212) 321-9458
Donna Rebel
Chairman
June 28, 1993
The Honorable Glenn English
Chairman
Subcommittee on Environment, Credit,
and Rural Development
Committee on Agriculture
U. S. House of Representatives
Washington, DC 20515-6001
Dear Mr. Chairman:
Commodity Exchange, Inc. (Comex) was pleased to learn of the
June 30 hearing and markup before your Sucommittee on H.R. 2374,
a bill to amend the Commodity Exchange Act to ensure continued
application of the Act's anti- fraud and anti-manipulation
protections. Due to scheduling conflicts I will be unable to
testify at the hearing; however, I would like to express Comex's
views on the pending bill.
H.R. 2374 would prohibit the CFTC from granting exemptions from
the Commodity Exchange Act's anti-fraud and anti-manipulation
provisions unless the exempted transactions or persons would be
subject to comparable anti-fraud protection under the Federal
securities and banking laws, as determined by the Commission.
Comex supports the bill and your continued efforts to ensure the
integrity of U.S. futures markets.
Comex firmly believes the American public is best served by
markets where prices are reached openly and available for all to
see. As the Commission uses its exemptive authority it should
seek, to the maximum extent practicable, to ensure comparable
treatment to exchange- and off-exchange-traded exempted trans-
actions and individuals. This approach, rather than protecting
the exchange or off-exchange markets from competing with each
other, is preferable. The Commission should be mindful that
granting an exemption to an off-exchange product without a
similar grant to its exchange-traded counterpart would likely
favor, in effect, the off-exchange over the exchange-traded
product. Also, failure to provide comparable treatment could
potentially hamper the ability of the affected exchange market
to serve its hedging and price discovery functions.
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We are unaware of any analyses concluding that retention of
anti- fraud and anti-manipulation authority by the Commission
will adversely affect the market for otherwise exempted
transactions. Retention of these authorities for otherwise
exempted transactions and persons can serve as a basis for
relief for participants in transactions found to be fraudulent
or manipulative.
Thank you again for this opportunity to express our views on
H.R. 2374. If I' or anyone on the Comex staff can be of
assistance as this bill continues through the legislative
process, please do not hesitate to call on us.
Sincerely,
Donna Redel
o
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